Equity Analysis and Valuation of Carter s Inc. Group Members:

Transcription

1 Equity Analysis and Valuation of Carter s Inc. Group Members: Garrett Reeves garrett.reeves@ttu.edu Nick Bullington nick.bullington@ttu.edu John Tyler Myers johntyler.myers@ttu.edu Travis Wood travis.wood@ttu.edu Brock Ables brock.ables@ttu.edu 1

2 Executive Summary Analyst Recommendation: Sell (Overvalued)...7 Industry Analysis... 8 Accounting Analysis Financial Analysis Valuation Analysis Company Overview Industry Overview Five Forces Model Rivalry Among Existing Firms Industry Growth Rate Concentration Differentiation Switching Costs Economies of Scale Fixed-Variable Costs Excess Capacity Exit Barriers Conclusion Bargaining Power of Suppliers Cost of Switching Differentiation Importance of Product Cost and Quality Number of Suppliers Conclusion Threats of New Entrants Economies of Scale First Mover Advantage Distribution Access Legal Barriers Conclusion Threat of Substitute Products Relative Price and Performance Buyer s Willingness to Switch Conclusion Bargaining Power of Consumers Differentiation

3 Price Sensitivity Consumer Retention Conclusion Key Success Factors Cost Leadership Firm Economies of Scale and Scope Low Cost Distribution Little Brand Advertising, Research, and Development Conclusion Differentiation Superior Customer Service Convenient Delivery Investment in Brand Image Conclusion Firm Competitive Advantage Analysis Superior Design/Quality Price Production/ Distribution Costs Brand Positioning Convenience Conclusion Key Accounting Policies Type One Key Accounting Policies Economies of Scale and Scope Low Distribution Costs Low Input Costs Efficient Production Type Two Accounting Policies Goodwill Operating and Capital Leases Pension Plans Conclusion Accounting Flexibility Goodwill Operating and Capital Leases Pension Plans Conclusion Evaluation of Accounting Strategy Research and Development

4 Goodwill Operating Leases Pension Plans Conclusion Quality of Disclosure Disaggregation Goodwill Conclusion Identify potential Red Flags Goodwill Operating Leases Undo Accounting Distortions Goodwill Capitalizing Operating Leases Conclusion Financial Statement Presentation Section (Re-statements) Goodwill Capitalizing Operating Leases Financial Analysis Cross Sectional Analysis Liquidity Ratios Current Ratio Quick Ratio Conclusion Operating Efficiency Ratios Inventory Turnover Accounts Receivable Turnover Working Capital Turnover Days Supply Inventory Days Sales Outstanding Cash to Cash Cycle Conclusion Profitability Ratios Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity Asset Turnover Ratio

5 Internal Growth Rate Sustainable Growth Rate Conclusion Capital Structure Ratios Debt to Equity Altman s Z-Score Times Interest Earned Conclusion Forecasted Financial Statements Income Statement As Stated Income Statement Restated Income Statement Balance Sheet As Stated Balance Sheet Restated Balance Sheet Cash Flow Statement Forecasted Cash Flow Statement Cost of Capital Estimation Cost of Equity Implied Cost of Equity Cost of Debt Restated Cost of Debt: Weighted Average Cost of Capital Method of Comparables P/E Trailing P/E Forward Price to Book Dividend to Price Price Earnings Growth Price to EBITDA Price to Free Cash Flows Enterprise Value to EBITDA Intrinsic Valuation Models Discounted Dividends Model Discounted Free Cash Flows Model Residual Income Model Residual Income Model (Restated) Long Term Residual Income Long Term Residual Income (Restated)

6 Valuation Conclusion Regressions Amortization Schedule References

7 Executive Summary Analyst Recommendation: Sell (Overvalued) 7

8 Industry Analysis The baby apparel industry is categorized as being very competitive and the firms in the industry are all categorized as price takers. Our group found Carter s Inc. main competitors to be Children s Place, Gap, and Disney. While Children s Place and Gap are very comparable to to Carter s, Disney is not as comparable. Due to the large number of other companies that Disney owns it is hard to compare the company to the rest of the industry and in almost all of the metrics used Disney was categorized as an outlier. The industry has seen growth over the last five years and this growth is expected to continue into the future. Because there is little differentiation among firm s products these firms compete with one another by keeping their distribution costs down through established distribution channels, economies of scale, and maintaining efficient production operations. We used the five forces model to further analyze the industry and the chart shows this analysis is below. As the chart above shows, rivalry amongst firms is categorized as high due to there being low differentiation among products, a low level of concentration, low level of 8

9 switching costs, firms not having much excess capacity, and a low level of exit barriers. This results in firms in the industry being price takers. The only way firms are able to compete with one another and set themselves apart is through economies of scale. The bargaining power of suppliers is categorized as low due to the industry seeing low switching costs, a low level of differentiation, large number of suppliers, and cost being more important than quality for most firms. This result in better prices for the firms in the baby apparel industry since the negotiating leverage lies with them instead of their suppliers. The threat of new entrants is categorized as mixed. While metrics such as economies of scale, first mover advantage, and distribution access indicate it would be hard for a new firm to enter the industry and steal market share, metrics such as legal barriers to enter indicate it would not be that difficult. In addition, the threat of a large firm that is already in the retail industry is always present as they already have already established distribution channels, take advantage of economies of scale, and have their brand name behind their products. Lastly, the threat of smaller boutiques entering the industry to sell specialty type clothing is always present as well. A large number of boutiques together steal market share from Carter s Inc. The graph on the following page shows this well. The threat of substitute products is categorized as low because of buyer s extremely low willingness to switch. The only other option would be to hand make the clothes at home. There is just no substitute to clothing for a person s child. 9

10 The bargaining power of consumers is categorized as high due to there being little product differentiation between firms that would keep consumers loyal and consumers being very sensitive to prices. This results in consumers not worrying as much about the brand name they are buying as much as they are worried about the price they are paying. In conclusion, the five forces model indicates that the industry is very competitive and all the firms in the industry are price takers. Firms are able to set themselves apart through economies of scale and efficient operations. Accounting Analysis In order to properly value a company, the company s accounting practices must be analyzed in comparison to firms within the baby apparel industry. The General Accepted Accounting Principles, or GAAP, allows for a relatively large degree of flexibility in reporting financials, and therefore, understanding a company s financial accounting and disclosure is extremely important. Because GAAP allows for a large amount of 10

11 accounting flexibility, companies can easily manipulate financials in order to mislead investors, banks and analysts. Firms with a high level of financial disclosure can be much easier to value than those who have low disclosure because a company s core values are more transparent. By evaluating Carter s Type 1 Key Accounting Policies that are revealed through industry analysis and Type 2 Key Accounting Policies that are much easier to manipulate, we were able to determine the areas of Carter s accounting policy that is distorted. Type 1 Key Accounting Policies evaluate the level of disclosure regarding economies of scale and scope, low distribution costs, low input costs, efficient production, and goodwill. These policies are properly disclosed within the company s 10-K and are not a level of concern when valuing the company. Type 2 Key Accounting Policies evaluate the firm s disclosure regarding goodwill, operating leases, and company pension plans. The disclosure given relating to goodwill and operating leases was considerably low, therefore we have identified the two categories as potential red flags. Company pension plans on the other hand have a high level of disclosure and there are no issues with how the plans are reported in Carter s 10-K. All of the leases which were taken by Carter s are categorized in their financials as operating leases. This can create a large distortion within the company s financials because the leases are not recognized as a liability and instead are recognized as a rent expense. The 10 year average operating lease obligations that Carter s acquired are a very significant liability, and therefore must be analyzed as a liability rather than a rent expense. By capitalizing the leases and adding them to the balance sheet, we change the capital structure of the firm by increasing Carter s liabilities and increasing their net income in order to properly value the company. In order to create a higher level of disclosure of Carter s financials, we have capitalized all of their operating leases as 11

12 capital leases and added them to the company s forecasted financials located further into this financial report. Carter s took on a very large amount of goodwill when it acquired OshKosh in 2005 and Bonnie Togs in 2011, and has not adequately impaired goodwill over the years. There are periods of time where Carter s goodwill is nearly one and a half times the value of its fixed assets, creating distortions within their balance sheet. By having such a high value for goodwill, the company s assets are overstated and its expenses are understated. In order to properly represent Carter s financials, we have restated its goodwill in the report below in order to properly value the company. Given the degree of disclosure for Carter s financials, we have concluded that their financials are not adequately stated in order to properly value the company, and therefore, we have restated them within this analysis. Financial Analysis Determining the value of a firm requires careful analysis of many different forms of financial analysis such as ratio analysis, financial forecasting, and estimating the firm s cost of capital. These different forms of financial analysis are not only taken from the firm that is be evaluated but also their competitors in the industry to accurately represent its performance against the industry over a period of time. Ratio analysis involves gathering information in a firm s financial statements that can be broken into four categories; liquidity, operating efficiency, profitability, and capital structure. Liquidity ratios will measure a firm s ability to satisfy its short-term debt obligations with current assets. When comparing Carter s liquidity ratios such as their current and quick ratio, Carter s was consistently above the industry average. This shows that Carter s is more financially set than the industry in terms of liquidity. Since the restated financial statements do not differ in current assets and current liabilities the ratios are the same for as stated and restated. 12

13 Liquidity Ratios Ratio Comparison Trend Current Ratio Above Average Decreasing Quick Ratio Above Average Decreasing Operating efficiency ratios include inventory turnover, accounts receivable turnover, working capital turnover, days sales of inventory, days sales outstanding, and cash to cash cycle. These ratios measure the efficiency of a firm s management decisions. In our evaluation we concluded that Carter s is below average in regards to inventory turnover, accounts receivable, and working capital turnover. Being below the industry average on these ratios shows that Carter s is slow in turning over inventory, collecting receivables, and generating sales through its working capital. Carter s days supply inventory, days sales outstanding, and cash to cash cycle are all above the industry average. This shows that it takes more time for Carter s to sell their inventory and collect their accounts receivables. These ratios are the same in regards to as stated and restated. 13

14 Operating Efficiency Ratios Ratio Comparison Trend Inventory Turnover Below Average No Trend A/R Turnover Below Average Decreasing Working Capital Turnover Below Average No Trend Days Supply Inventory Above Average No Trend Days Sales Outstanding Above Average No Trend Cash to Cash Cycle Above Average No Trend Another important aspect to analyze when determining how valuable a firm is their profitability ratios. The profitability ratios are used to assess a firm s ability to generate sales compared to the expenses they incurred during a period of time. Profitability ratios include gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, return on equity, sustainable growth rate, and internal growth rate. This is the first set of ratios that differ from as stated and restated financial statements. With the as stated ratios being average and above average shows that Carter s does a good job generating profit with their sales. The restated ratios are on average and above the industry average. This is good for Carter s because even after accounting for goodwill and operating leases that brings their net income down, their profitability ratios are still either average or above the industry. The only ratio that is below the industry average is asset turnover, which is reasonable because we have more assets after we restated our balance sheet. Having more assets on the restated 14

15 balance sheet also resulted in Carter s return on assets to be lower than the as stated but still among the industry average. Profitability Ratios Ratios Comparison Comparison Trend Stated Restated Gross Profit Margin Average Average No Trend Operating Profit Margin Average Average No Trend Net Profit Margin Average Average No Trend Asset Turnover Average Below Average No Trend Return on Assets Above Average Average No Trend Return on Equity Above Average Above Average No Trend Sustainable Growth Rate Above Average Above Average No Trend Internal Growth Rate Above Average Average No Trend Capital ratios indicate how a firm finances their operating activities. These ratios do not measure a firm s performance like liquidity, operating efficiency, and profitability ratios do. Capital ratios are computed to show if the firm uses a lot of debt or equity to pay for their operating activities. These ratios include debt to equity, times interest earned, and Altman s Z-score. Carter s is above average on both as stated and restated debt to equity ratio. A high debt to equity ratio compared to the industry means that Carter s uses more debt to pay for their operating activities than the industry. Carter s times 15

16 interest earned is below the industry average showing that they may be paying down too much debt with earnings that could be used to finance other projects. Having an above average Altman s Z-score on their as stated ratios shows that they are less likely to become bankrupt compared to the industry average. However, their restated Z-score is 3.99 which slightly below the industry average but is not currently in a position to be concerned with bankruptcy. Capital Structure Ratios Ratio Comparison Comparison Trend Stated Restated Debt to Equity Above Average Above Average No Trend Times Interest Earned Below Average Below Average No Trend Altman s Z-score Above Average Below Average No Trend After performing the ratio analysis, we moved to forecasting Carter s financial statements. The purpose of forecasting a firm's financial statements is to give us a better representation of the future financial well-being of the firm. In Carter s forecasted financials, we used different ratios, observable growth rates, and trends in both Carter s and the industry to accurately calculate the different values. The forecasted as stated and restated financials will have some of the same values and some different due to capitalizing operating leases and amortizing goodwill only affecting certain accounts. There is no way to correctly forecast all financial statements, but we now have an idea of Carter s future well-being if the observed trends continue. 16

17 The final step of financial analysis of Carter s is estimating their cost of capital. This included us calculating Carter s cost of debt and equity and their weights based on their capital structure. For cost of equity we used the capital asset pricing model. This model uses the company's Beta, risk-free rate of return, and the market risk premium. Once we calculated cost of equity we moved on to Carter s cost of debt. To calculate the cost of debt we used their weighted average of liabilities while applying the correct interest rate for each liability. Once we have cost of debt and equity we were able to calculate their weighted average cost of capital on a before and after-tax basis. Valuation Analysis After conducting the ratio analysis, forecasting, and estimating the cost of capital, we can now value Carter s. Throughout our valuation analysis we used the observed share price of Carter s on April 1, 2016 of $ This observed share price will be included in the different valuation models to figure out if they are overpriced, underpriced, or fairly priced. With a 10% safe zone, any numbers outside can be reasonably considered overpriced or underpriced. Our analysis consists of two methods of evaluation: method of comparables and intrinsic valuation models. The comparable analysis consists of trailing price to earnings ratio, forward price to earnings ratio, price to book ratio, dividend to price ratio, price earnings growth ratio, price to EBITDA ratio, price to free cash flow ratio, and enterprise value to EBITDA ratio. In our comparable analysis the adjusted share price is consistently lower than Carter s 10% confidence interval. Although these models are do not have as much weight as the intrinsic models, the fact that Carter s is consistently overpriced gives us more confidence with our analyst recommendation. The intrinsic valuation model consists of the discounted dividend model, free cash flow model, residual income model, and long run residual income model. These models are thought to be be more reliable than the methods of comparables as they implement 17

18 firm specific information rather than industry averages. As with the methods of comparables, the intrinsic models were consistently overvalued. Overall, after an industry overview, an in depth accounting analysis, forecasting future financials, and estimating appropriate costs of capital we are confident in our analyst recommendation of overvalued. END OF EXECUTIVE SUMMARY 18

19 Company Overview Carter s Inc. is a major American manufacturer and retail seller of children s apparel headquartered in Atlanta, Georgia. The company was established in 1865 and its mission is to serve the needs of families with young children by providing a strong value in our product offerings including baby apparel, sleepwear, playclothes, and related accessories. Carter s has the broadest distribution of young children s apparel in the industry and own the largest market share of the $20-million-dollar baby apparel industry. The firm achieves this by operating 18,000 wholesale locations and 731 company owned stores in the United States. In addition, Carter s reaches consumers in over 60 countries through wholesale and licensing relationships and in over 100 countries through their websites. Carter s achieves success by taking advantage of economies of scale through their production and distribution operations. Below you can see a chart for sales volume and growth throughout the past five years. The growth has been due primarily to the growth of the e-commerce and retail sectors of Carter s as well as the general growth of the global economy. Figure 1 19

20 Industry Overview The baby apparel industry consists of both a retail and wholesale sector. Both of these channels are very competitive and because of that the industry is categorized as a price taking industry. Success of the industry is highly correlated to the overall success of the economy and has seen growth over the last 5 years of around 10.9%. Looking forward, the industry is expected to continue to see growth over the next 5 years as well. While the industry is projected to grow over the next five years, the baby apparel industry is subject to general economic downturns and a slowing birth rate in places like the United States and Canada. The baby apparel market is unique in that the people purchasing the product are not the ones using the product but instead are buying it for someone else. As a result, baby apparel is marketed towards women and emphasizes quality over anything else despite cost being the industry's actual number one concern. Firms in the industry set themselves apart from one another by keeping their costs down and offering their product at a lower price. Assuming that all the firms are producing clothes of a relatively decent quality price becomes the most important factor. Five Forces Model Financial analysts and companies use Porter s five forces model to analyze competition among firms in a particular industry. The five forces include competition among existing firms, the threat of new entrants, the threat of substitute products, bargaining power of buyers, and bargaining power of suppliers (hbr.org, Porter s Five Forces). This is important to analyze because the analysis of the five forces shows if an industry is one in which the combination of the five forces acts to drive down profitability or the five forces combine to increase profitability through decreased competition. The baby 20

21 apparel industry is very fragmented with many competitors, indicating a high level of competition among firms. Each force will be classified as high, mixed, or low competition. With this information, investors can develop a broad and sophisticated analysis of competitive position between the firms. Listed in the table below is how the five forces apply to Carter s Inc. Rivalry Among Existing Firms The children's apparel, footwear and accessories retail markets are highly competitive (Children s Place, 10-K, p.11). Carter s largest competitors include Children s Place, Gap, and Disney. Other competitors also include regional retail chains, catalog companies, and various Internet retailers (Carter s 10-K). One of the reasons behind this highly competitive market is that fixed costs in relation to variable costs are relatively low, which keeps the barriers to entry low as well. In addition, firms in the industry are exposed to the fact that consumer s tastes and demands can and do change, and input prices can vary due to an issue with a supplier or another exogenous event (Gap 10-K). These factors, combined with the fact that most consumers in the baby apparel market do not make their buying decisions on any particular product differentiation other than price, cause the industry to be highly fragmented and highly competitive. 21

22 Industry Growth Rate The industry growth rate is analyzed to not only see how firms within an industry compare to one another but to also compare the industry as a whole to an overall economic benchmark such as the S&P 500 or Dow Jones. Industries with higher than average growth rates are good candidates for new investments as a high growth rate is seen as a very bullish sign. Firms in the baby apparel industry attempt to increase their growth by extending the reach of their brand with various marketing techniques and improve profitability by increasing the efficiency of various aspects of the firm s operations. Regarding the issue of company growth Carter s Inc. stated: Below is a graph showing industry growth over the last 5 years on a YoY basis. Figure 2 Looking at the data dating back to 2011, it can be seen that overall the industry has continued to grow. This growth mirrors the growth of the US economy as a whole, using the Dow Jones Industrial Average as an indicator. With the US economy performing better people have had more disposable income to spend on items such as baby apparel. This increase in sales allows the firms to use the extra income to further 22

23 expand business by increased marketing operations and expand other facilities necessary to business operations such as production facilities. Concentration How many firms are competing within an industry and how close they are to being the same size is referred to as the concentration. An industry that has fewer firms, such as automobiles or the airline industry, is considered to be highly concentrated while an industry that is highly fragmented with many smaller firms is considered to be a highly fragmented one. The baby apparel industry is highly fragmented. The barriers to entry are relatively low due to low start up costs and while there are distinct brand names within the industry, firms within it do not rely solely on this fact to maximize sales. Instead of relying on brand recognition like some industries do, firms rely economies of scale and established distribution channels to get their product to as many consumers as possible at the lowest possible cost. These are both things that can be outsourced to a third party though, hence the abundance of private label companies, which helps keep initial start up costs down for new entrants. Understanding the structure of the industry and how concentrated it is helps show the threat of new entrants. In addition, the production of baby clothing does not require any proprietary information that is not available to other firms. Below is a chart that represents the baby apparel market and shows how market share is divided between them as of

24 2015 Market Share 60.00% 50.00% 49.6% 40.00% 30.00% 20.00% 10.00% 16.4% 13.5% 9.2% 11.3% 0.00% Carter's Inc Gap Children's Place Disney Private Label & Others Figure 3 While there are some major firms in the industry, as indicated above, there is also a large percent of the market that is divided up between numerous firms that all are relatively small such as regional retailers and internet outlets, Carter s, who owns the largest market share, only accounts for 16.4% of the market. In addition, there are many private label companies that hold almost 50% of the market. This high level of fragmentation leads to a high level of competition and leaves the threat of new entrants high due to the large number of firms driving down profits for everyone in the industry. Differentiation Analyzing differentiation within an industry is important because it shows whether a firm in an industry is a price setter or a price taker. For example, if a firm in the baby apparel industry created a product that was vastly different from the rest of the products in the industry it would be categorized as a being a price taking product. This allows a firm to experience an economic profit based on the higher price charged. In an 24

25 industry that is not highly differentiated though the firms must simply focus on minimizing costs throughout the production chain in order to realize a higher profit than their competitors. The baby apparel industry would be one that is classified as having a low level of differentiation. Firms within the industry all produce similarly designed products with only slight differences. Even though there are certain trademarks owned by some firms they are not enough of a factor to be considered a major factor that sets certain firms apart. The one exception to this industry wide trend is Disney. They have a number of trademarks relating to the characters they have created. This is not an industry wide trend though and it is why the industry would still be categorized as having a low level of differentiation. Switching Costs Switching costs in an industry are the costs incurred if a firm were to switch to an alternative industry. The baby apparel industry has low switching costs. It would not cost a firm much time or capital to switch from making baby apparel to adult apparel as the firm already has all of the equipment to produce clothing. In addition, a firm would be able to take advantage of its previously established distribution channels, economies of scale, and relationships with other retail companies to make the new business venture profitable. Economies of Scale Economies of scale for the large manufacturers, such as Carter s, Children s Place, or Gap are very important in the baby apparel industry. While boutiques that offer more expensive and market concentrated choices are not as worried about the price of the cost of goods sold, the large firms in the industry must compete with one another on reaching a certain price point or they will lose market share. Being a large firm in the industry allows a firm to spread its fixed costs out across many units of production, which helps keep costs of production down on a per unit basis. In addition, firms are 25

26 able to purchase the inputs for their product in large quantities and therefore receive wholesale prices. These economies of scale result in higher gross margins for the large firms. Carter s is one of these large firms that sees these benefits because of their economies of scale and Gap is as well. Fixed-Variable Costs Looking at a firm s fixed and variable costs help show how the firm should set their prices and base their operations in order to maximize profit. The ratio is found by dividing fixed costs by variable costs. A firm that has higher fixed costs in relation to variable costs is one that relies on high volume in sales and low input costs for their products and margins tend to be very thin and prices relatively low. High profits are realized from a high quantity of goods sold. On the other hand, a firm that has high variable costs in comparison to fixed costs operates by having less volume in sales but a higher profit margin per unit sold. The way a company is set up is not as much a choice of the firm as it is the nature of the industry the firm operates in. In the baby apparel industry firms have a high fixed to variable cost ratio because the factories and machines that are used to manufacture the clothes are expensive and therefore rely on a high number of sales to cover those fixed costs. Gap and Disney both are firms that base all of their profit projections on having a high number of sales with very thin margins. This style of operating has its benefits. It acts as a natural risk management tool because even if their sales numbers end up being slightly less than projected the firm still has a high number of sales to cover their fixed costs. Firms that operate on the other side of the spectrum do not have this luxury as a small variance in sales ends up being a significant difference in revenue due to profit margins being larger. As a result, industries with a lower fixed to variable cost ratio create products that have higher costs per unit while industries with a high fixed to variable cost ratio price their products lower per unit. The graph below shows this ratio. 26

27 Total Fixed Cost to Variable Cost Ratio Carter's Gap Children's Place Disney Figure 4 Excess Capacity The amount of excess capacity within an industry is a strong indicator of both the health of the industry and the overall demand for the industry s products. A firm that has a high level of excess capacity will most likely be struggling to turn a profit. A firm that is producing at its optimal level of output will be seeing a maximized profit. A good indicator of a firm s excess capacity is the sales to property plant, and equipment (PPE) ratio. Using this ratio shows how efficient a firm s assets are in creating sales revenue from the fixed assets they have on hand. The higher the ratio is indicates that a firm is operating closer to its full capacity. Below is a graph representing this ratio in visual form among various firms within the baby apparel industry. 27

28 Figure 5 Overall, the industry is relatively efficient in their operations. This makes the industry very competitive because it shows little room for someone to enter the industry and operate in a more efficient manner. It also shows that firms must operate efficiently in order to gain market share, further indicating that competition is high among firms in the baby apparel industry. Exit Barriers Exit barriers refer to how difficult it would be for a firm to leave the industry that it is currently operating in. Exit barriers include very specific machines used to manufacture products or very industry specific knowledge required by employees. The baby apparel industry is one that would be categorized as having low exit barriers. It would be relatively easy for a company to shift their product focus to other lines of apparel because they do not have specialized equipment and their distribution channels would already be established. Also, employees of the firms in the industry would not have trouble applying their knowledge and training to another industry. 28

29 Conclusion Rivalry amongst firms is classified as high in the baby apparel industry. There is a low level of differentiation between most products, low level of concentration, low barriers to entry, and low exit barriers as well. All of these factors being classified as low, in addition to all the other data calculated thus far, makes competition between firms very high and therefore the rivalry amongst firms is very high as well. Bargaining Power of Suppliers The amount of bargaining power suppliers to an industry has is very important when analyzing profitability. All companies need raw material as inputs to keep the business running and when suppliers have the bargaining power, they have the ability to charge the purchaser of their product a premium. The bargaining power of suppliers can be represented by the ratio of suppliers to buyers. If there is an abundance of suppliers in the market and the product is easy to obtain, buyers will have many alternatives to obtaining these materials. This will cause the bargaining power of suppliers to be low. When there are fewer suppliers available in the market the suppliers will have greater bargaining power. There is an abundance of suppliers of raw materials for baby apparel and they mostly come from Asia. According to an article published by the Economist in March of 2015 titled Made in China? the reason behind this is the established distribution channels and low cost of labor. Cost of Switching Switching costs are the costs that a company takes on when switching from one supplier to another. An industry that has few suppliers will have higher switching costs than one with many suppliers. In an industry that has limited suppliers the suppliers will have leverage over the companies trying to purchase the products, causing the cost of switching to be higher. 29

30 Carter s sources products from a network of suppliers, mainly in Asia. Carter s sourcing network currently consists of over 140 vendors located in 17 countries with one source controlling 70% of their total inventory purchases and their current sourcing agents have been meeting their operation requirements (Carter s, 10k, p.8). Children s Place states that they maintain relationships with many manufacturers in various countries and are currently switching their suppliers from China to other developing countries. Differentiation The level of differentiation in products from suppliers is another factor that is considered in how much bargaining power the supplier has. When there are many different suppliers with different materials, the buyer has to choose which one best fits its needs. The suppliers will take advantage of that and price their product higher because there is a demand for it. This is an example of the supplier having bargaining leverage. When there is less differentiation between one supplier and another they do not have as much leverage over the buyer of their product. In the baby apparel industry, the suppliers do not have much differentiation between their products, resulting in less bargaining power. Where they can differentiate themselves from others is through their pricing, accountability, quality, and customer service. Importance of Product Cost and Quality In the baby apparel industry, the importance of the cost and quality of the material used in the clothes are vital in the bargaining power of suppliers. Price is extremely important to the buyers and is a reason for switching suppliers if prices rise too much. Taken from Children s Place 10-K, In order to maintain and/or reduce the cost of our merchandise, we have reduced and will continue to reduce production in China and have moved and will continue to move production into other developing countries. In addition, the products must still maintain high quality or the cheaper prices are not worth it. 30

31 The suppliers in the baby apparel industry do not differentiate themselves very well since the raw material they are providing is so similar and simple. Because of this, there is not much room for suppliers to offer cheaper prices or higher quality materials in order to increase their bargaining power. Number of Suppliers The number of suppliers in an industry is an important factor when considering how much bargaining power each supplier has. A firm in an industry with many different suppliers has the ability to pick and choose between many different options. When suppliers are scarce, the buyer does not get to compare as many prices and quality of the raw material. In the baby apparel industry there are many suppliers available for the firms to choose from. This is shown by the number of suppliers Carter s, Children s Place, and Gap all have to supply their raw goods. Conclusion After taking into consideration switching costs, differentiation, the importance of cost and quality, and the number of suppliers, it is apparent that the firms in the baby apparel industry have bargaining power over their suppliers. With each supplier having similar products, it would be hard for them to differentiate themselves from each other. This provides the baby apparel firms with bargaining power over their suppliers because if the supplier does not meet their standards, they can easily find another one. Threats of New Entrants Just as with any industry, firms in the baby apparel market must be cognizant of potential new entrants. Because there is already a magnitude of clothing companies that exist throughout the world, the threat that an already existing company will enter the market with a baby clothing line is always present. 31

32 Companies that enter into the industry are often subdivided into two groups. These two groups consist of retailers who already have shelf space in the apparel industry and are simply expanding their line of products in order to enter into the baby apparel industry, and companies who have no prior existence and are focusing their efforts on creating a new baby apparel firm. The baby apparel industry is already dominated by major players, therefore, companies who seek immediate entrance into the baby apparel market often pose much less of a threat than apparel and clothing companies who are simply expanding their product line. Below, we have listed and detailed five major barriers of entry that companies must overcome in order to steal market share in the baby apparel industry. Included in these threats are economies of scale, first mover advantage, access to distribution, relationships, and legal barriers. Economies of Scale Economies of scale relate to the cost advantages a firm sees due to the increased output of a product. For example, in the baby industry, a company that is able to successfully produce and sell a large amount of products will encounter lower fixed costs per unit, and therefore, increased profit margins on a per unit basis. Throughout the baby apparel industry economies of scale are a threat to potential new entrants. Firms throughout the industry rely on economies of scale to keep production costs down and they are only able to achieve this by producing a large quantity of units. This is very important in the baby apparel industry because it plays a factor in keeping new entrants out. First Mover Advantage First mover advantage refers to a firm's ability to enter into the industry before any other firms in order to capture market share. By entering into the industry before potential competitors these firms create industry standards, build relationships with suppliers, and build reputations with customers. For these reasons, it is very difficult to enter into an industry that has already been dominated by other firms. 32

33 In the baby apparel industry, firms that are able to enter into the industry first acquire two major advantages compared to those who have not. These advantages consist of relationships with suppliers as well as customers because they are able to develop brand name awareness. By being a first mover in the industry, companies can create long lasting relationships with their suppliers that later entrants cannot. When you combine this type of a relationship with the customer loyalty that a firm experiences after years in the industry, it can be very difficult to persuade consumers to switch to a new product. When purchasing baby apparel, customers often think of the firm that offers the most convenient and well-known baby clothes. Therefore, through early entry, companies raise brand awareness to the point where consumers will continue to purchase their brand of apparel over a new entrants products. Distribution Access Distribution access is a measure of a firm's ability to manufacture products and distribute them to customers. Throughout this process, firms must develop relationships with manufacturers who create their products, the suppliers of the raw product the firm uses to create the end product, as well as the retail stores that market the final product. In the baby apparel industry, there are two major distribution channels; the wholesale channel where manufacturers distribute products to retailers who then sell the products to consumers, and the retail channel where products are manufactured and placed directly in firm owned retail outlets. Firms who choose to retail their products directly through their own retail outlets directly influence price points in order to generate the maximum amount of revenue possible. While this may sound beneficial, these firms must also fund the high cost of operating and managing an extensive chain of retail outlets. This creates a major barrier of entry in the apparel industry, as a firm must have capital to expand their business from the manufacturing sector and into the retail sector. The other channel, where firms wholesale their products to other retail outlets, is a much cheaper alternative in regards to opening a retail chain, but can reduce 33

34 profits in the long term. The wholesale channel can also create a barrier of entry that is challenging for companies entering into the industry because the baby apparel firm that is trying to find a market for their products is going to have to negotiate and develop a proper relationship with retailers in order to be successful. Because of this, distribution access is very important in the baby apparel industry. Legal Barriers Legal barriers to entry refers to the legal issues a firm may face in order to enter a certain industry. Industries that see a high level of regulation typically are categorized as being industries with high legal barriers to entry. Industries with a low level of regulation see the opposite effect. The largest legal barriers in the baby apparel industry relate to patents and copyrights. Companies who create products for babies and children often have logos and designs that are patented or protected. These designs can prevent other firms from being able to create certain products. Overall though, in the baby apparel industry legal barriers to entry are not an issue. Conclusion When analyzing the threat of new entrants in the baby apparel industry one must take into account all of the above topics. When doing so it is apparent that the threat of new entrants is low for major retailers such as Gap or Carter s Inc. but the threat is high for smaller boutique firms. This is because of aspects such as economies of scale and distribution access. Threat of Substitute Products Substitutes or alternatives to products are products that could potentially replace the original product. In the baby apparel industry there are very little threats of substitute products because babies require certain apparel and clothing that cannot be substituted for a different product. The only substitute to purchasing baby clothing would be to 34

35 make it from home. Before retail stores became large in the United States, there were a number of people who made clothes themselves, however; in today s culture, there is no substantial threat to the baby apparel industry. Relative Price and Performance If a product is created that has relatively good performance or quality in comparison to the original product and can be sold at the same price, or a lower one, a firm will be threatened by the substitute product. When this occurs, the already existing firms will quickly lose market share. While there are very few substitutes for already existing products, variations of already existing products can pose a major threat to existing firms in the baby apparel industry. It is very common in the baby apparel industry for a major firm to develop a quality product that is highly demanded by all consumers. From here, another company will slightly modify the product and produce it at the same quality, or slightly lower quality, and market it at a discounted price. This can be detrimental to some firms as they lose market share based on the theory that people are willing to compromise on quality if the product can sufficiently complete its job and is sold at a discount. Buyer s Willingness to Switch Given that there are no substitute products for baby clothes other than hand making it at home, buyer s willingness to switch is very low. The opportunity costs incurred from hand making clothes at home make the endeavor not worth the time, regardless of how much money is saved from doing so. Also, most people would not have the skills to do so either, even if it was worth the time. Conclusion While the only real substitute for children s apparel is to create it at home by hand, variations of products are likely to steal market share from already existing firms if products can be marketed at a similar quality or at a lower price. The threat of an 35

36 absolute substitute is very unlikely in the baby apparel industry as very few people want to sacrifice the convenience of purchasing baby clothes to make the clothes themselves, however, the variations that different firms are able to create of products can be very effective in stealing market share from existing firms. Bargaining Power of Consumers The bargaining power of consumers is defined as how much influence the consumers have over an industry s price and the quality of the products. If there are a large number of consumers in comparison to firms, then the firms have a high degree of bargaining power. If there is a large number of firms competing for a set amount of consumers, then the consumers have a high degree of bargaining power. In the children s apparel industry, there are many firms competing for the same customers, giving the bargaining power to the consumers. Differentiation Differentiation refers to how much one company s products differ from another s within the same industry. In industries with low differentiation between products, consumers hold the power, which forces firms to have lower, more competitive prices. With high differentiation, a firm is able to set their product above the rest based on different factors such as quality and design. In the baby apparel industry, there is a mixed amount of differentiation, as consumers will pay a small premium for quality clothing. But, since the product is very simple, there is little to no opportunity for innovation. This means competitors will have little difficulty replicating a similar product for a discounted price. When you add in the factor of online purchasing, there is hardly any product differentiation. With little product differentiation, the consumer holds the majority of the bargaining power, as there is little the firm can do to set their product apart from the rest (Gap, 10-K). 36

37 Price Sensitivity The amount of bargaining power of buyers is almost directly correlated with price. If a company cannot keep prices down they will likely suffer due to the fact that consumers can obtain a similar or even better product for a discounted price. In the baby apparel industry prices are very important. Most consumers do not have the luxury of being able to pay for more expensive items and because of this, they tend to buy the cheaper product. Gap, Carter s, and Children s Place are all subject to price sensitivity (Gap 10-K, Carter s 10-K, Children s Place 10-K). Consumer Retention Customer retention is the ability for a firm to keep a customer as a loyal one over time. In the baby apparel industry, over the long run, customers are only worried about price. Because of this, customer retention is hard to achieve. Over the short run, a firm can charge a higher price and rely on brand loyalty to still maintain market share but this is not the case over the long run. This is true for all firms in the industry. Conclusion The baby apparel industry is very competitive. Carter s, Gap, Children s Place, and Disney are all sensitive to price, have a hard time retaining customers over the long run, and do not have much product differentiation between them. Because of this, the bargaining power of consumers is considered high for the industry and all firms within the industry are considered price takers. Key Success Factors In order to gain a competitive advantage above other firms, there are two routes a firm can take. A firm can either become a cost leadership firm or a differentiation firm. Cost leadership firms focus on maintaining very low costs in order to maximize profits. These types of firms can afford to have similar products to competitive firms, but are able to 37

38 make profits by having lower costs with a comparable amount of quality. By implementing economies of scale, low input costs, and low distribution costs, cost leadership firms are able to enhance their profits. Industries that have cost leadership firms often have very comparable products offered at different prices. In comparison to a cost leadership firm, a differentiation firm focuses on product flexibility and variety. Rather than focusing on low prices, these types of firms spend more money to create higher quality products to better entice customers. As a whole, the baby apparel industry is focused on a mixture of both cost leadership, and differentiation depending upon the firm. Below we will recap the details of each type of key success factor. Cost Leadership Firm Cost leadership firms are centered around cutting costs related to all types of production and manufacturing in order to sell products at the lowest possible price. These types of companies use economies of scale along with tight control systems to maximize their revenues. Baby apparel companies focus their efforts on economies of scale, low cost distribution, and little research, development, and brand advertising in order to function as cost leadership firms. Economies of Scale and Scope Economies of scale are used throughout the industry in order to lower the cost of production. According to economies of scale, as you produce more of a product, the price of the product will decrease on a per unit basis. Gap, Inc. shows in their 10-k that they engage in economies of scale and scope in order to produce a high amount of product to place into their inventory to sell while limiting the costs required to produce the product on a per unit basis (Gap, Inc. 10-k). By maximizing economies of scale, firms develop proper relationships with their suppliers in order to ensure low production costs over a long time period. 38

39 Low Cost Distribution In order to further cut costs, firms in the baby apparel industry engage in low cost distribution. Be acquiring products at discount prices from suppliers and then mass distributing them to the wholesale and retail industry, the firm can cut significant distribution costs. Firms in the industry such as Children s Place state that they focus their efforts on developing premier relationships with suppliers in order to deliver the best quality product, and the lowest possible cost, therefore, limiting distribution cost. The company has even constructed a 700,000 square foot distribution center in Alabama in order to further cut distribution costs (Children s Place 10k). After acquiring products from suppliers, firms further cut costs by mass distributing to wholesale and retail sectors. Gap, Inc. builds up a large inventory within its retail sector in order to cut distribution costs and ensure ample inventory is always available (Gap 10-k). By acquiring products at low costs through mass distribution and proper supplier relationships as well as mass distribution to wholesale and retail channels, baby apparel firms can successfully engage in low cost distribution. Little Brand Advertising, Research, and Development Baby apparel firms are able to operate with very little research, development, and brand advertising. When analyzing firms in the industry such as Gap, Children s Place, and Carter s there is no disclosure of any research and development expenses, showing low costs for R&D. In regards to advertising, company 10-k s reflect the industry s ability to limit advertising costs based on both technological innovation, which eliminates mail ads and unnecessary signage, as well as a company's ability to bypass advertising based on a previously developed brand image. According to GAP, Inc. s 10- k, the company s largest asset is its iconic brand image that has been developed over the years, and is able to consistently attract customers (Gap, Inc. 10-k), therefore, illustrating the power of their already developed brand image. Children s Place shows a continual decrease in advertising costs over the year s as a result of technological 39

40 innovation and repeated customer product approval (Children s Place 10-k), further illustrating the industry s ability to limit brand advertising research and development. Conclusion Firms in the baby apparel industry successfully operate as cost leadership firms due to their economies of scale, low cost distribution and little development and advertising. By maximizing the amount of products they both produce and bring to market, profits can be maximized due to low costs. Combining this aspect with low R&D, and a previously developed brand awareness that works to eliminate advertising, the industry has even further cut costs in order to function as an industry comprised of cost leadership firms. Differentiation Firms utilize differentiation in order to set themselves apart from other industries. By utilizing tactics such as superior quality, variety, customer service, innovation, flexible delivery, and investments in brand image, firms try to out do each other in terms of quality. While the baby apparel industry tends to be more related to cost leadership, by partaking in some differentiation strategies such as customer service, convenient delivery, and investment in brand image, firms can complement their low cost strategies in order to attempt to create the perfect brand. Superior Customer Service Baby apparel firms must pay special attention to customer service, when looking to please customers and generate a profit. Carter s states in their 10-k that they continually look to provide customers with a consistent, high level of service. They go on to state that Our retail stores and websites focus on the customer experience through store and website design, visual enhancements, clear product presentation, and experienced customer service (Carter s 10-k). Children s Place also speaks about the importance of Customer service and loyalty, (Children s Place 10-k). These 40

41 comments illustrate the importance and desire for firms in the baby apparel industry to provide customers with the highest level of service possible as repeat sales and customer loyalty are a significant factor to success. Convenient Delivery Since the development of the internet, the baby apparel industry has resorted to online sales as a medium for exchange. Children s Place states in their 10-K that Our customers are able to shop online, at their convenience, and receive the same high quality, value-priced merchandise and customer service that are available in our physical stores, illustrating how the company has enabled customers to have more convenient delivery methods while maintaining a superior level of customer service (Children s Place 10-k). Not only this, but firms seek out retailers in all locations in order to place products right at the hands of their consumers. With company s such as Gap who operate over 3,300 retail stores, customers can purchase products in store as well as online (Gap, Inc., 10-k). By expanding both online operations and retail operations among firms, the baby apparel industry has created a convenient delivery method for all customers. Investment in Brand Image Brand image can be very important to firms in the baby apparel industry. Children s place and Gap have dedicated an entire section of their 10-k to brand image, and both speak about its importance in maintaining customer loyalty. Carter s 10-k states that one of the greatest focuses of the company is to drive their brand image to the top of the baby apparel industry in order to continually generate sales (Carter s 10-k). These statements illustrate the ways that a firm in the baby apparel industry can generate sales by maintaining positive brand image. Carter s states that it can enhance its brand image by focusing on core areas and products in order to make their products a common household name among the retail industry. By focusing on brand image and 41

42 product familiarity, the baby apparel industry has consistently generated sales over the years. Conclusion The overall goal of a firm in the baby apparel industry when utilizing differentiation is to work to enhance the name of the brand itself. While it is important to develop high quality products, companies who develop a strong, positive brand image are able consistently attract customers over many years. The industry engages in differentiation to attempt to create products and a brand that is superior to their competitors. All firms in the baby apparel industry provide very similar products, therefore, it is important to differentiate your brand name and services in order to be successful. Firm Competitive Advantage Analysis Carter s is one of the leading firms in the baby apparel industry. It has done this by creating strategies specific to their industry that create competitive advantages for the firm. Like many firms in this industry it uses a combination of both cost leadership and differentiation in order to increase both its profits as well as its customer satisfaction. By creating and manufacturing products of superior quality and design, selling its products at attractive prices for consumers, keeping production and distribution costs relatively low, positioning the brand effectively, and by offering convenient channels to distribute products, Carter s has created and maintained a competitive advantage over its competitors. Superior Design/Quality In order to remain competitive in the baby apparel industry, a firm must create products of superior design and quality. As clothing trends come and go, firms must constantly update their designs and invest in new inventory. Carter s has had to modify its product designs over the years so that they may remain a firm that is looked highly upon by the consumers. It has done this by fabric improvements, new artistic 42

43 applications, and implementing new packaging and presentation strategies in order to continue to meet these demands (Carter s 10-K, 2). In order to further illustrate the importance of updating product designs, Children s Place 10-k states The apparel industry is subject to rapidly changing fashion trends and shifting consumer preferences. Our success depends in part on the ability of our design and merchandising team to anticipate and respond to these changes. Our design, manufacturing and distribution process generally takes up to one year, during which time fashion trends and consumer preferences may further change (Children s Place 10- K). Carter s designs clothes for a variety of product categories such as baby, sleepwear, and play clothes for a range of ages. While these categories are closely related, they are specialized to some degree, giving Carter s differentiation in their product lines. Price Because the baby apparel industry is highly concentrated and firms offer very similar products, firms in the industry must create a price advantage. Carter s 10-k states that the firm attempts to compete on price in a way that creates adequate profit while creating quality products for their customers (Carter s 10-k). Children s Place states that they are able to offer a brand name at quality prices, in order to attract customers and remain profitable (Children s Place 10-k). By implementing economies of scale in in order to lower costs on a per unit basis, and offering a fair price to customer s, firms create favorable margins giving them a competitive advantage in terms of price. Production/ Distribution Costs As previously stated, Carter s uses economies of scale in order to maximize profit margins while delivering products of high quality to the consumer. By combining this with e-commerce distribution and company owned retail stores, like many other industry competitors, the firm is able to create a competitive advantage by limiting production and distribution costs. Carter s has invested in a one million square foot 43

44 distribution center in order to support their fast growing online sales while continually operating over 500 retail stores within the United States (Carter s 10-k). By using online and retail distribution, Carter s creates higher profit margin by bypassing major retailers that can substantially limit their profit margins. Along with inexpensive distribution, Carter s currently sources over 70% its products from a Chinese supplier in order to cut distribution costs and produce maximum amounts of product (Carter s 10-k). These methods of production and distribution significantly increase profit margins within the firm and and industry in order to create a competitive advantage. Brand Positioning Brand positioning is a key aspect to the baby apparel industry as companies constantly invest in their brands in order gain a better position in the market. Carter s aggressively positions its products in a way that assures it will remain a leader in baby and children s clothing to its customers. Carter s has done this by store-in-store fixturing, branding and signage packages, and also through advertising. Carter s has invested in display fixtures to give to their products an aesthetically pleasing presentation in all forms of retail. Along with this, Carter s insures that the customer gets the satisfaction they are looking for through clear product presentation and experienced customer service (Carter s 10-K, 2). Convenience In the baby clothing industry, convenience often drives customers to purchase products from specific firms. Carter s excels in this category by offering their products in retail stores such as JCPenny s, Macy s, Toys R Us, and Walmart (Carter s 10-k). Along with its wholesale sector, Carter s offers an online store as well as Carter s Retail Stores. By providing three different channels of product distribution, the firm creates a competitive advantage of convenient product deliver. 44

45 Conclusion Since its founding in 1865 Carter s has been a leader in the baby clothing industry. It has done this by using a combination of both cost leadership and differentiation methods to create competitive advantages over its competition. In cost leadership it has been able implemented economies of scale in both production and distribution to reduce costs. In differentiation, Carter s has set itself apart from competitors by designing multiple product lines in order to reach a breadth of customers. Carter s has become a leader in the baby clothing industry through successful brand positioning and convenient product delivery. Key Accounting Policies Key accounting policies are the specific policies a firm uses to prepare its financial statements and analyzing these procedures will allow us to identify how aggressive or conservative a firm is when reporting earnings. There are two types of key accounting policies that should be looked at when analyzing a firm. Type one key accounting policies are related to the key success factors discussed previously. The second type of accounting policies are ones that have the potential to be distorted and can have a large effect on the financial statements. Analyzing all of the key policies for Carter s and comparing them to other firms in the industry will allow us to gain a better understanding of Carter s true value. Type One Key Accounting Policies Key success factors in the baby clothing industry generally revolve around ways to keep costs down. Carter s type one key accounting policies are economies of scale and scope, low distribution costs, low input costs, and efficient production. 45

46 Economies of Scale and Scope Economies of scale are the advantages that a firm sees as their production increases. As production increases costs decrease on a per unit basis. Firms in the industry achieve this by having large-scale operations and facilities. For example, Children s Place operates a 700,000 square foot facility in Alabama to help achieve economies of scale. Carter s achieves economies of scale by operating a one million square foot distribution center in Georgia where all E-Commerce sales are distributed though. There is no disclosure for any firms in the industry that directly discuss economies of scale. Low Distribution Costs Firms in the baby clothing industry generally keep their distribution costs down in various ways. However, costs are still an inevitable part of distribution. For Carter s, these costs include things such as related labor costs, shipping supplies, and certain distribution overhead. Carter s absorbs these expenses under selling, general, and administrative expenses. The table below shows how efficient firms in the industry are at keeping their distribution costs down. Operating Expenses over Sales Carter's 23.89% 28.38% 31.49% 29.82% Gap 26.37% 27.02% 25.66% 25.59% Children's Place 32.28% 33.28% 32.79% 30.78% Disney 26.67% 25.91% 24.57% 22.52% It can be seen that Carter s is one of the best at keeping distribution costs down. Children s Place on the other hand does not do as good of a job. These ratios had to be 46

47 calculated for all firms in the industry except Gap, which disclosed the ratios in their 10- K. Low Input Costs Input costs are the expenses incurred when a firm manufactures a product. The purchasing power of the firm is critical to this policy as the more raw materials purchased at once leads to lower prices. Along with this, if the firm is able to achieve economies of scale it brings these input costs down even further. Carter s does not disclose any information directing relating to input costs except that they are subject to price fluctuations. Gap offers more disclosure regarding their input costs by providing tables such as the one below. Efficient Production Efficient production is having the ability to keep costs as low as possible throughout the production process. This starts with low input costs, as mentioned above. The industry in general does not have a high level of disclosure and Carter s is no different. The only information that was available in Carter s 10-K was, The Company s product costs are subject to fluctuations in costs such as manufacturing, cotton, labor, fuel, and transportation. Conclusion As shown above, firms in the baby apparel industry attempt to separate themselves from the competition by keeping their costs down and operating in the most efficient manner possible. As a whole though, the firms do not disclose very much information 47

48 on these policies. This is not a cause for concern though because all of the success factors for the baby apparel industry are cost based and show up in the financial statements. They are not policies such as brand image or product variety that are strategy based and need to be disclosed in a company s 10-K. Type Two Accounting Policies Type two accounting policies are the significant items on the balance sheet or income statement that managers have a high degree of flexibility on how to report. Manipulating these items to a higher or lower level can distort how the balance sheet or income statement appears to potential investors. For example, overstating goodwill leads to a firm s assets being overvalued. The items that have been identified as type two key accounting policies for Carter s are goodwill, operating and capital leases, and pensions. Goodwill Goodwill comes into effect when one company purchases another. It is an intangible asset that arises from the buyer in a transaction paying a premium to purchase another company. Meaning the buyer ends up paying more than the book value of the company being purchased. Goodwill is hard to measure because there is no way to put an exact value on it. It includes things such as brand name recognition, customer service reputation, potential future value, and other things that do not have a direct monetary number to attach to them. It is calculated by taking the price paid by the company acquiring the other and then subtracting the purchased companies actual book value. Represented algebraically it would be; acquisition price - book value = goodwill. It is necessary for all firms to perform goodwill impairment if the company wants to accurately portray its net income. Carter s does this at the reporting unit level and failure to do so can result in an overstatement of net income over time. Below is a table 48

49 showing the effect failure to perform proper goodwill impairment can have on the income statement or balance sheet. Assets = Liabilities Equity Revenues Expenses = Net Income Overstated No Effect Overstated No effect Understated Overstated As can be seen, a firm s treatment of the goodwill listed on its books can have a large effect on the firm s financial statements. Events and conditions that go into Carter s assessing of goodwill listed are global macroeconomic conditions, market and industry conditions, and other cost factors. As for Carter s treatment of its goodwill, the firm acquired Bonnie Togs in 2011 and per GAAP rules will not be amortizing the goodwill that stemmed from the purchase. The other goodwill listed on the income statement and balance sheet is comprised of trade names and non-compete agreements. Some of the trade names are being amortized while others are not and all of the non-compete agreements were amortized over time and finished doing so in 2014 (Carter s 10-K). Operating and Capital Leases Firms within any industry have a choice when deciding how to list leases on the financial statements by either book it as a capital lease or as an operating lease. If the lease is considered a capital lease it must then be considered an asset and all risk of owning the lease falls on the lessee. In addition, a capital lease leads to an apparent reduction of the firm s return on assets and the firm s asset turnover. In the case a leased item or property is listed as an operating lease, all risk falls on the lessor and the lease is not listed on the balance sheet. Because of this, firms typically list leased items or properties as operating leases instead of as capital leases if they can do so. Looking at Carter s 10-K shows that the vast majority of the firms leases are listed as operating leases. Only 0.3% of all the firms leases are listed as capital leases. This is important 49

50 for shareholders to look at when trying to find the value of a firm due to the potential that some leases should really be capital leases instead of operating leases. Pension Plans A pension plan is a type of retirement plan where an employer makes contributions towards an investment fund that is set aside for an employer s future benefits. Pension plan finances have the potential to be distorted because there is no set discount rate that must be used, certain average age of death for their employees, or expected rate of return. Due to the long time frame taken into account for pension plans and the large amount of money involved a small change in the discount rate or expected rate of return can have a large affect on the financial statements. Carter s offers its employees a pension plan among other retirement options and the firm has a high level of disclosure. Below is the chart that appears in the company s 10- K. As can be seen, both the discount rate and the expected rate of return are laid out very clearly and the 10-K also discusses how they decided on what rates to use. In addition, Carter s discloses how much a.25% change in the assumed discount rate would change their projected benefit obligation. Conclusion Carter s does distort both goodwill and their leases. However, they do not distort their pension plan and do a very good job of laying out all the numbers and how they chose 50

51 them. The distortion of goodwill and leases is a cause for concern and will require them to have to be restated. Accounting Flexibility Observing the flexibility that managers have when recording values on a company's books is the next step in the accounting evaluation process. High flexibility can make it difficult to accurately value a company due to under and overvaluation. In the case though where there is little to no accounting flexibility among managers, book values are often very true and correct, accurately stating a firm's value. The accounting process and its rules are regulated by GAAP, the Generally Accepted Accounting Principles, who is regulated by the Financial Accounting Standards Board, or FASB. GAAP and FASB set the minimum accounting standards that must be followed by firms throughout the country, therefore, allowing, or disallowing managers to engage in this flexibility discussed. Goodwill Goodwill is an intangible asset that results when a company acquires another at a premium that is higher than the company's listed assets. Firms pay this premium as a result of the acquisition of intangible assets such as positive brand name, customer base, patents, trademarks, and acquired technology. Managers very easily overstate the value of goodwill on the balance sheet in order to increase the value of assets that the company holds in order to appeal to its shareholders and encourage investing. Goodwill is not amortized but it is instead reviewed on a yearly basis and is subject to impairment. Because this impairment has a high degree of flexibility assets can easily be overstated. For example, when a manager has not adequately amortized goodwill the company s assets, net income, and equity will remain overstated as well, resulting in understated expenses. 51

52 Because goodwill accounts for a larger portion of Carter s assets than it should goodwill is considered to be overvalued, therefore, increasing the valuation of the firm. Operating and Capital Leases When reporting leases they are either classified as capital or operating leases. Companies have incentive to list their leases as operating leases in order to keep the debt that comes with a capital lease off the balance sheet. There are certain requirements set out by GAAP that classify a lease as either operating or capital. Therefore, companies who are able to categorize their leases as operating leases even though they are actually capital leases have the ability to do so. Even with regulations in place, GAAP at times provides a very high level of flexibility in regards to recording balance. Managers take advantage of this in many cases to maximize the outlook of their companies to the general public. Carter s does not include any capital leases on its balance sheet meaning they have most likely have off balance sheet debt that isn t being reported. Pension Plans Pension plans have a high degree of flexibility in their reporting. Aspects such as discount rate, expected rate of return, and expected mortality rate are all flexible and there is no set rate that must be used. As a result, firms can use whatever rates they want which could greatly distort what they actually end up paying out to employees or what kind of returns they end up seeing from their investments. Carter s is very transparent in their reporting and modeling. In addition, the benchmarks they use such as the Citigroup Pension Discount and Liability index for their discount rate are widely accepted throughout the finance industry. The expected rate of return though is much more flexible as Carter s, considers historic returns adjusted for 52

53 changes in overall economic conditions that may affect future returns and a weighting of each investment class (Carter s 10-K). Conclusion There are a number of ways that companies are able to distort a firm s financials in order to make the firm appear stronger from a financial perspective. By overvaluing a firm s financial statements appear stronger it helps stimulate investing and make securing financing easier. Even with accounting regulations and guidelines there are always methods to improve a company's image without having to directly affect its performance. Evaluation of Accounting Strategy Managers have a lot of leeway in how they report various accounting items. To analyze the level of financial disclosure that a firm reports, one must compare a firm s key accounting policies not only to GAAP standards but to other firms within the industry as well. A company categorized as having a low level of disclosure will report simply the GAAP minimum requirements and a firm categorized as having a high level of financial disclosure will go above and beyond what they are required to report. Varying levels of disclosure cause firms to appear over or undervalued. Research and Development Research and development costs may be modified on a company s balance sheet based on the firm s level of disclosure. This is not a major concern in our analysis as research and development accounts for a very small expense within the retail industry. Goodwill Goodwill is an intangible asset that arises when one company acquires another. It represents the premium the buyer paid over the book value of the company being acquired. Because it is an intangible asset it has the potential to be manipulated and 53

54 companies frequently do change how they amortize or impair it based on many factors. Virtually all firms perform what is referred to as an impairment test to get a better idea of what their goodwill and other intangible assets are actually worth. Carter s is very forthcoming in reporting the carrying value of their goodwill and other intangible assets even though it does appear to be very overstated. They have amortized certain items such as their brand name in Chile, non-compete agreements stemming from their Bonnie Tog acquisition, and Carter s Watch the Wear and H.W. Carter & Sons trade names. While they are amortizing some of their intangible assets, the acquisition of Bonnie Togs is not being amortized. Other firms in the industry have similar policies in regards to reporting the carrying value of their goodwill. Gap, Inc., Carter s largest competitor, is also very forthcoming on the carrying value of their goodwill. Taken from their last 10-K: During the fourth quarter of fiscal 2014, we completed our annual impairment review of the trade names and we did not recognize any impairment charges. We determined that the fair value of the Athleta trade name significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of the Intermix trade name exceeded its carrying amount by approximately 30 percent as of the date of our annual impairment review (The Gap, Inc. 10-K). Below is a chart showing Carter s ratio of goodwill to plant, property, and equipment. It is a good indicator of if a firm has over or undervalued its goodwill. As can be seen, Carter s goodwill is much higher compared to their fixed assets. Showing such high value over values the firm by making goodwill, and can make an intangible asset such as goodwill appear as if it is a fixed asset

55 Carter s Inc The Gap, Inc Operating Leases Leases have different effects on a company's books depending on their classification. Because an operating lease does not have to be put on a company s books, when one is taken, a company s liabilities are undervalued. Due to this accounting flexibility, it is very likely that a company may be over or undervalued depending on the types of leases that are taken. According to Carter s 10K: The Company enters into a significant number of lease transactions related to properties for its retail stores in addition to leases for offices, distribution facilities, and other uses. The lease agreements may contain provisions related to allowances for property improvements, rent escalation, and free rent periods. Substantially all of these leases are classified as operating leases for accounting purposes. It is clear that Carter s is actively obtaining operating leases, and they have a very high level of disclosure. Below is a table detailing Carter s contractual cash obligations by year (Carter s 10-k). 55

56 Pension Plans Carter s does a good job disclosing its pension plans in their 10-K. Throughout Carter s 10-K, the company states the expected values of their pension plans over the next five years, and discloses both discount rates and expected rates of return. Along with these values Carter s gives detailed descriptions as to how they are calculated. Carter s provides a discount rate for each pension plan with the most recent year 2014 reported as 3.50%. According to the St. Louis Federal Reserve, the corporate bond yield for that year reported was 3.79%, which is a very conservative method. The lower discount rate used decreases the company s retained earnings and increases their liabilities, showing very conservative accounting. Conclusion Carter s has a very high level of financial disclosure compared to its competitors. This is very helpful in valuing a company because transparent financial statements leave very little for questioning. The baby apparel industry is an industry that is based on customer service, brand reputation, and honesty, therefore, companies strive to obtain a positive reputation through displaying transparent information to their customers and shareholders. Quality of Disclosure The quality of disclosure for company s financial statements is directly linked with the accuracy and quality of the information provided, therefore, quality of disclosure is a very important attribute when valuing a company. If a company only discloses only information required by the General Accepted Accounting Principles requirement, one may be suspicious of the actual position of a company. A company that discloses more than just the bare minimum information will leave a better impression on the people looking over their financial statements. 56

57 Carter s financial statements are very thorough and in-depth. They provide a substantial amount of detail regarding general information about the company as well as financialrelated data. From reviewing the amount of information provided on the financial statements, Carter s appears to have provided more than the information required by the General Accepted Accounting Principles. The Company demonstrated transparency by including risk factors that could ultimately affect its future successes. Over ten pages of the Company s 10-K are dedicated solely to potential threats. Taking this initiative communicates to the reader of the financial statements that the Company recognizes areas of weakness and is not trying to undermine the risks. When moving on to the financial portion of the 10-K, the footnotes are very concise, easy to follow, and easy to understand. The footnotes provided great explanation in regards to why something was documented the way that it was. In addition to the footnotes, the quarterly comparison of data for the current year makes it easy for the reader to compare and judge the Company s financial performance Disaggregation In regard to disaggregation, the Company does a nice job separating between its retail and wholesale sectors of Carter s and OshKosh, as well as their International sales. Carter s provides different tables to let the reader easily see the differences in different aspects of their business. They provide this information prior to the consolidated financials, which helps the user have a better understanding of what all is being included in the data. For example, Carter s discloses that they will be discontinuing their Japan retail sector and provides tables showing decreasing revenues forecasted over the following years. Carter s discloses a high degree of disaggregation disclosure because they do engage a number of operations within other countries and have a variety of different sales methods. The information shows that the retail sector and online sales sector accounts for the largest percentage of revenue. With Carter s efficient use of disaggregation it 57

58 allows its readers comprehend their information easily especially in comparison to their competitors financials. Goodwill Carter's does a good job disclosing how it allocates its values of goodwill. They provided step-by-step information on how they evaluated their goodwill. A portion of the goodwill for Carter's was acquired by the acquisition of Bonnie Togs. On June 30, 2011, the Company purchased all of the outstanding shares of capital stock of Bonnie Togs for total consideration of up to CAD $95 million, of which USD $61.2 million was paid in cash at closing (Carters 10-k, p. 64). The 10-k continues to disclose more information on the process of acquiring Bonnie Togs. This acquisition of Bonnie Togs made up 25% of Carter s new reported goodwill in The ratio of goodwill to PP&E is just over 54%. This number seems to be large for a company that has not had any significant changes in goodwill or acquisition since Their goodwill has also been decreasing which shows that they haven t been acquiring any in the last couple years. With the decreasing goodwill value, it at least tells us they are slightly recognizing the fact that nothing has been acquired since 2011, but with a ratio of goodwill to PP&E over 54%, they are not impairing it enough. This is a sign to us that goodwill needs to be amortized to have a more accurate representation. Conclusion Overall, it appears that Carter s did a nice job putting together their 10-K. It is clean, concise, and easy to follow for the most part. The financials appear to be useful and transparent to those who are interested in their performance for There seems to be more than enough information provided about the company, which shows the confidence of the company. After analyzing Carter s quality level of disclosure, the company appears to have a relatively high level of quality of disclosure. 58

59 Identify potential Red Flags Red flags in this context are defined as being an area for possible errors or problems within the financial statements. Though Carter s financials appear to be presented fairly and without material error, there is always the threat of red flags buried within the data. For Carter a possible red flag is in regards to Operating Leases and goodwill. Goodwill One potential red flag we have found is in concerns with goodwill. Carter s goodwill to PP&E ratio is high at 54%. In relation to their tangible assets, their total intangible assets are too high. The fact that their goodwill is such a large portion of their assets raises concerns in regards to their financial statements. Their goodwill totals from 2013 were $186 million and has only been impaired down to $182 million in 2015, this impairment was only from the Bonnie Togs portion and not anything else. This also raises concern that they are not impairing enough when it comes to goodwill. Carter s does not amortize any intangible assets except for three of the five components of tradenames and non-compete agreements. With a lack of amortization of goodwill and the two major trade names, these assets could be overvalued at this point since the amount reported is not changing. Operating Leases Another potential red flag we have found is how much the firm s leases are listed as operating leases. Carter s only listed.3% of their leases as capital leases. While there is a great degree of flexibility when it comes to deciding how to classify their leases, it is significant that they chose to report basically all of them as operating leases. The effect of such a large portion being operating leases will cause the firm's net income to be lower with such a large amount of operating lease expenses. The effect of this will also undervalue the liabilities. With understated liabilities, they have minimized risk with less long-term debt reported. The result of this action will make the company seem more attractive in the long run. 59

60 Undo Accounting Distortions Since firms have some flexibility in financial statement reporting, accounting distortions may exist. Firms can have their company appear to be more valuable than it actually is through various accounting methods. A few examples of this would be over-valuing inventory, the amount of capitalized operating leases, how they capitalize research and development, and how they amortize goodwill as well as the amount of impairment on it. Depending on these factors, a firm can appear to be worth more than it actually is. For example, if a firm mainly reports operating leases instead of capital leases, it is expensing the leases every year and not showing them under long-term debt, which would understate the company s liabilities. This scenario would help the company minimize risk according to the balance sheet and appear more valuable to investors. Another example would be the amount of capitalized research and development reported. Research and development costs are expensed on the income statement, so the amount capitalized is how much is reported on the balance sheet through increasing assets. Research and development is obviously something that some firms use to gain a competitive advantage and should be capitalized to show an accurate representation of how much they benefited from the expense. The capitalized amount can be understated or overstated, leading to inaccurate amounts on the balance sheet, which again can lead to a firm appearing more valuable to its investors. The following table represents Carter s Balance Sheet and Income Statement after the changes made based on the restatement of a few accounts. 60

61 61

62 Goodwill For Carter s, we have identified two major red flags in financial reporting. The first being the high ratio of goodwill to property, plant, and equipment. For 2015, the ratio sits at around 54%, which is an alarming amount. A previous table compared Carter s ratio of goodwill to PP&E to GAP s ratio, and it was evident that Carter s ratio is too high. Further, they are not amortizing any goodwill, and the only change in amounts from 2014 to 2015 goodwill is represented by an impairment of the Bonnie Togs acquisition, which is about 25% of the total goodwill reported. Basically, there was zero impairment reported for the remaining 75% of goodwill, which was not recently acquired, and no amortization of that amount. Carter s hasn t acquired any assets since the 2011 acquisition of Bonnie Togs, so it seems that they are not in a position to allow that amount of goodwill to substantially decrease if they want to appear valuable. The trade names that have not been amortized most likely still hold the stated value, but the excess value, or goodwill, should have been impaired. To restate their financial statements, we decided to amortize the goodwill over a straight line, 5 year period. We amortized the original amount of goodwill that Carter s had listed before the Bonnie Togs acquisition, which is where the comes from. The Bonnie Togs acquisition occurred in 2011, so we amortized it over a 5-year period, 62

63 meaning by the end of 2015 it s goodwill had been completely amortized to its residual value. Year Goodwill (Stated) Amortization Expense Ending Balance Goodwill Restated Year Beginning Balance New Impairment (27.31) (27.31) (27.31) (27.31) (27.31) 0 New Impairment** (10.42) (10.42) (10.42) (10.42) (10.42) Ending balance *In millions of USD Carter s has not acquired any goodwill since the Bonnie Togs acquisition in 2011, which is why the previous balance of goodwill needs to be amortized. This will decrease the 63

64 goodwill asset account and increase the amortization expense account, which will decrease net income. Capitalizing Operating Leases The other potential red flag we identified was Carter s choosing to recognize an insignificant portion of their leases as capital leases. To fix this, we will capitalize the firm s operating leases to help the balance sheet have a more accurate representation of Carter s liabilities. We used the next 5-year operating lease commitments, as well as the remainder balance spread out over the 5 years after that. The balances can be found on page 39 of the 10-K, and we used the interest rate given. An interest rate for long-term debt can be found on the previous 10-Ks since 2013 but not before that, so we had to assume the same interest rate of 5.5% for 2009 to As of now, the balance sheet states an account for capitalized operating leases, but the amount is zero. The amount listed for the restated account represents the present value of future lease commitments. As shown in the table by the percentages, adding the leases to the balance sheet represents a very significant change in non-current liabilities. Below is a table showing the capitalized future amounts over a 10-year period. Year Non-Current Liabilities Capitalized Operating Leases Restated Total with Leases % Change of Non-Current Liabilities 178% 192% 230% 172% 184% 190% 64

65 *In millions of USD Conclusion After restating the balance sheet for goodwill and operating leases, a significant change is made in how assets decreased, liabilities increased, as well as expenses increasing in both scenarios. In the end, once the income statement accounts are adjusted the balance sheet will balance, but will also show more debt. This is why Carter s chooses to not amortize goodwill or capitalize their operating leases. By changing how they recognize the specified accounts, as proven above, makes their firm appear less attractive to investors. The complete calculations for the restatements can be found in the appendix. Financial Statement Presentation Section (Restatements) For Carter s, we had to do two restatements of their financial statements, which were goodwill and operating leases. The complete calculations of the restatements can be found in the appendix. Goodwill The goodwill Carter s recorded on their balance sheet represented over 30% of the net fixed asset (property, plant and equipment), and in most cases was over 50%. To restate the goodwill account, we amortized the amount listed on a straight-line, fiveyear period. Year Goodwill (Stated) Amortization Expense

66 Ending Balance Goodwill Restated Year Beginning Balance New Impairment (27.31) (27.31) (27.31) (27.31) (27.31) 0 New Impairment** (10.42) (10.42) (10.42) (10.42) (10.42) Ending balance *Amounts listed in millions of USD **New impairment represents 2011 Bonnie Togs acquisition With the five-year amortization, by 2013, goodwill represented less than 30% of property, plant, and equipment, which was the threshold we needed to achieve. This decrease in goodwill over a six-year period decreased total assets significantly in the most recent years. This is most evident in 2015, where Carter s reported $175 million in goodwill, but after the straight-line impairment, there was no remaining amount. This is because they have not had an acquisition since the 2011 acquisition of Bonnie Togs, which took place five years ago. Any acquisition since then would have been recorded as goodwill, but none have taken place. We decided to impair the goodwill over a five-year period because the amount originally recorded no longer represented a competitive advantage for Carter s. The amount was from over six years ago, so we needed to impair it. 66

67 The goodwill amount Carter s presented stayed fairly constant, and they listed no amortization expense on it each year. For impairment, Carter s states in the 10-K that to determine if impairment is needed, they may utilize a qualitative assessment to determine if it is more likely than not that the fair value of the reporting unit is less than its carrying value, (Carter s K). If it is determined that goodwill may be impaired, they go into a two-step process to calculate the amount. By using the terms more likely than not, Carter s seems to be giving a vague answer or explanation to any questions regarding a lack of impairment. Capitalizing Operating Leases Carter s lists all of their lease obligations as operating leases, meaning they are not represented on the balance sheet. The threshold for restating leases is if capitalizing the operating ones would increase the non-current liabilities by at least 20%, and for Carter s capitalizing the leases would increase it by over 50% for each year over the past six years. This is an extremely significant change since Carter s long-term debt is very understated. For example, in 2015, Carter s lists long-term debt at $584 million, and the present value of the capitalized leases is $787 million. The long-term debt more than doubles when capitalizing leases is taken into account. For our restatement of the past six years, we had to assume an interest rate of 5.25%. Each 10-K from 2013 to the most current year states that Carter s uses a 5.25% interest rate for long-term debt, therefore, we had to assume that it would remain the same for the prior years since they did not note an interest rate. Another assumption made was how long to capitalize each set of future obligations. On their 10-K, Carter s lists the amount of future leases for each of the next five years, then a lump sum of the remaining amount. We divided the lump sum total into five more years, which gave us a reasonable total for each year. That is how we came to a ten-year capitalization. The amount listed as capitalized operating leases for each year 67

68 represents the present value of future lease obligations, which were previously classified as operating leases. As previously discussed, capitalizing Carter s operating leases raises a major red flag in the amount of long-term debt recorded. The following table summarizes how significant of an effect on liabilities this capitalization creates. Year Non-Current Liabilities Capitalized Operating Leases Restated Total with Leases % Change of Non-Current Liabilities 178% 192% 230% 172% 184% 190% *Amounts listed in millions of USD The complete calculations for capitalizing operating leases can be found in the appendix. As you can see from the chart, this change makes a big difference in the amount of liabilities reported on the balance sheet. In 2012, the leases more than doubles the amount of non-current liabilities recorded. This increase in debt would make Carter s appear less attractive to investors, which is most likely why they choose to list all of their leases as operating. Overall, this capitalization almost doubles longterm debt each year, which is a very significant change for any firm in regards to the amount of debt recorded. The increase in debt will also increase Carter s leverage now that they have more long-term debt recorded. The perception of profitability of the firm can also be affected, due to the fact that these restatements have decreased total assets and increased liabilities. Overall, the restatements will negatively affect the perception of Carter s. 68

69 Financial Analysis Financial Analysis is now required in order to determine the value of Carter s Inc. In order to gain a better understanding of the company via financial analysis, we must analyze a number of financial ratios. By comparing ratios which include operating efficiency, liquidity, profitability and the firm s capital structure with other competitors in the baby apparel industry, we are able to determine possible market segmentation. Below we will discuss the various types of ratios and their implications. Operating efficiency ratios are used to illustrate a company s management efficiency by analyzing efficiencies across all operations. In cases where companies have low operating efficiencies, there is often a high level of excess costs. A company can use operating efficiency to then decrease unneeded costs in order to gain desired profits. Profitability ratios are a measure of a company s profitability that is used to define its performance. In the case of these ratios, high margins are desirable because they show the company s ability to generate a profitable yield on their products and services. Liquidity ratios are used in order to determine the cash that a company has on hand in order to pay off its short-term debt obligations. These ratios are crucial to a company s success as they determine whether or not a company will be able to pay off creditors. Liquidity can play a major role in a company s success as it can often prevent situations such as a bankruptcy and can also attract investors and banks. In order to show how a company finances its operations, we analyze capital structure ratios. When financing operations, companies can either use debt financing or equity financing. Debt equity occurs when a company finances its activities through bank loans, which can be very risky as they must take on greater liability and interest in repaying the principle. By financing through equity, interest payments and the principle amount can be avoided. By comparing Carter s capital structure ratios with that of competitors in the industry, the company s debt risk can be analyzed. 69

70 Cross Sectional Analysis Throughout the following section, we will use a cross sectional analysis in order to compare the operating efficiency, profitability, capital structure and liquidity ratios among Carter s competitors. By analyzing the ratios of Carter s three main competitors, GAP, Disney, and Children s Place, and the industry average, we will be able to see how Carter s competes with industry and competitor s standards. Below we have graphed the following ratios for Carter s and its competitors in order to see how the company stands within the industry. Liquidity Ratios In order to keep up with short term debt, liquidity is very important to a firm s success. The two most important ratios used to measure a firm s liquidity are the current ratio and the quick ratio. By analyzing a company s current liabilities, current assets, and inventory, which are all located on a company s balance sheet, we can determine the company s liquidity and its ability to pay short term debts. It is imperative that companies within the retail industry have a high level of liquidity within their company as firms experience a promotional retail environment, changes in consumer demand, and a competitive retail market that leaves them susceptible to reductions in profitability and increased expenses (Carter s 10K). These aspects of the retail industry increase the importance of liquidity, ensuring a company will be able to pay its debts. Current Ratio The current ratio measures a company s ability to pay its short term debt with its current assets. This ratio represents how liquid the firm is. The ratio expresses a measure of the company s current assets by its current liabilities. By calculating this ratio, we are able to measure a company s ability to pay short term debts based on their current available cash and liquid assets. A desirable current ratio is greater than one showing that a firm can pay for its 70

71 Axis Title current or short term debt with its current assets. It still may be difficult to pay off current or short term debt due to a firm having current assets that are not easy to liquidate such as prepaid expenses. Current Ratio Carter's Stated Disney Gap Children's Place Industry Average All firms within the industry have a similar current ratio and there is no trend either up or down for the industry as a whole. In addition, all firms within the industry have current ratios greater than one. This indicates that all of the firms are in good enough financial health to pay back their debts if they were to come due at this time. Carter s current ratio is unchanged by the financial restatements because changing operating leases to capital leases only affects long-term assets and liabilities. Quick Ratio The quick ratio is a measure of the dollar amount of liquid assets that a company has compared to each dollar of current liabilities, and is another important ratio to examine when analyzing a company s liquidity. In order to calculate this ratio, the difference of a firm s current assets and inventory is divided by the current liabilities. This amount is then divided by the total amount of current liabilities. This ratio can be very helpful in determining direct liquidity of a company, as inventories are not as liquid as other 71

72 Axis Title current assets, therefore; the ratio is used in order to disregard inventories. On the following page is a chart and graph of Carter s and its competitor s quick ratios. Quick Ratio Carter's Stated Disney Gap Children's Place Industry Average The graph shows that the quick ratio follows a very similar pattern as the current ratio. This indicates that all firms within the industry keep a similar amount of inventory. Also, the quick ratios for all of the firms are not much less than the current ratio. This shows that the firms in the industry keep a small amount of inventory on hand. Lastly, Carter s quick ratio is above the industry average, which shows they are financially healthy and in a better position to pay their current debts if they were to come due. Conclusion All of the firms in the industry are sufficiently liquid. When looking at the current ratio, all firms are above one and when looking at quick ratio all firms are close to one or over it. This shows that all the firms have enough assets to cover their short-term debt obligations. Overall, Carter s has a high degree of liquidity meaning they able to convert their assets into cash in a reasonable time manner if needed. 72

73 Operating Efficiency Ratios Operating efficiency ratios are a measurement that show how well a company can convert assets such as inventory and accounts receivable into cash. A higher turnover of these assets leads to a firm being more efficient in covering liabilities through converting assets to cash. Inventory Turnover In order to measure how efficient a firm is at managing its inventory, it is useful to analyze the inventory turnover ratio. In order to calculate the inventory turnover ratio, you divide the firm s cost of goods sold by its inventory. Firms that have low inventory turnover ratios struggle with moving inventory off their product shelves. Low inventory turnovers expose a firm s products to depreciation while leaving large amounts of capital tied up in unsold inventory. A high inventory turnover ratio indicates a firm s ability to efficiently move products off their shelves and into customer s hands in order to generate revenues. On the following page is a graph of Carter s and its competitor s inventory turnover ratios. Inventory Turnover Carter's Stated Disney Gap Children's Place Industry Average

74 There is no apparent overall trend regarding inventory turnover in the baby apparel industry. While it is hard to tell from the graph above, there is a large spread among firm s inventory turnover ratios. For example, there is a 43% difference between Carter s inventory turnover ratio and Gap s in the year 2015 and Carter s is the lowest in the industry. This shows that Gap is much more efficient in turning over its inventory and therefore operates much more efficiently than Carter s. As a saving grace though, Carter s has been increasing their inventory turnover ratio over the last five years, indicating the firm is becoming more efficient at managing its inventory. If Carter s continues to increase this ratio in the years moving forward, then it is not much cause for concern. Disney has an inventory turnover that is significantly higher than the rest of the industry, which categorizes the firm as an outlier. The reason behind this is that Disney is a very diversified company that deals with many other business ventures that do not generate inventories but increases their cost of goods sold such as movies and theme parks. Because of this, it is hard to compare Disney to the rest of the industry. Accounts Receivable Turnover The accounts receivable turnover ratio is a measure of how efficiently a firm uses its assets and is a great indicator on how efficient the firm is at issuing credit to its customers and then collecting in a timely manner. A low ratio shows that the firm has been unable to efficiently collect on issued credit, and therefore, has capital tied up that could be used for other expenses and investments. In order to calculate the ratio, we divide total sales for the year by accounts receivable for the same year. On the following page is a chart illustrating Carter s and its competitors accounts receivable turnover ratio. 74

75 Axis Title Accounts Receivable Turnover Carter's Stated Disney Gap Children's Place Industry Average There is a large spread between the firms regarding accounts receivable turnover but this spread is becoming smaller in recent years. The reason behind this is not because of an issue in how some of the firms operate but is instead due to the structure of the firms. Children s Place has the highest accounts receivable turnover because all of its products are sold at retail locations that are owned and operated by the firm itself. This results in very low accounts receivable because everything is sold straight to the consumer in exchange for either cash or cash equivalents. This same concept is also true of Gap, which is why in 2015 the firm had essentially the same accounts receivable turnover as Children s Place. Carter s on the other hand deals in both retail and wholesale which requires some inventory to be sold on credit, increasing accounts receivable. This is also true of Disney. Overall, Carter s is one of the lowest in the industry in terms of accounts receivable turnover but no firms in the industry are having issues collecting on their accounts receivable. Working Capital Turnover In order to illustrate how effective a company is at generating sales through its working capital, we use the working capital turnover ratio. This ratio is computed by dividing a company s net sales by its working capital. A company s working capital is defined by its 75

76 Axis Title current assets minus its current liabilities. A company that has a high working capital turnover ratio is doing a great job of supporting its sales with its current assets and current liabilities. On the other hand, a lower ratio shows that a firm is unable to support its sales because it has invested in too much inventory and accounts receivables (Accounting Tools). On the following page is a graph and chart of Carter s working capital turnover ratio compared with its competitors. Working Capital Turnover Carter's Stated Disney Gap Children's Place Industry Average In regards to working capital turnover, Carter s is the lowest in the industry. This indicates that Carter s is less efficient than the rest of the industry at turning money on hand into sales revenue. While the firm is the lowest, it is not a large cause for concern because the difference between them and the rest of the industry is not that large. Also, as a whole, the industry does not see a large spread among firms. In addition, there are no recent trends within the industry with the exception of Disney and this difference is once again due to its operations in industries other than just baby apparel. Days Supply Inventory The days supply inventory ratio measures the given time period that it takes for a company to turn its inventory into revenue. The day supply inventory ratio is calculated by dividing the company's inventory by their cost of goods sold and then multiplying the 76

77 Axis Title ratio by a 365-day calendar year. When companies purchase inventory, they are unable to make other investments because there is excessive capital tied up in the purchase of inventory. By comparing the days supply inventory ratio of firms, we are able to compare the efficiency of firms in generating revenues off the purchase of their inventories. The lower the ratio, the faster a firm is able to generate revenue from their inventories, and the higher the ratio, the longer it takes for a firm to generate revenues based on the sale of their inventories, resulting in a longer time period that tied up capital cannot be used to generate profits. This ratio is also the first step in the cash to cash cycle which measures the time period in which a firm purchases inventories to its suppliers to the point where the firm receives cash from its customers. On the following page is a chart illustrating the day supply inventory of Carter s and its competitors. Days Supply Inventory Carter's Stated Disney Gap Children's Place Industry Average There is a large difference in days supply inventory among the firms in the industry and there is no trend either up or down. Carter s days supply inventory is significantly higher than the rest of the industry, indicating that they are not as efficient in turning their inventory into revenue. Gap, on the other hand, is very efficient at turning over their inventory and therefore they have a low days supply inventory. Having a lower days supply inventory means that Gap is better at managing their inventory and therefore they operate more efficiently. In recent year, Carter s has improved their days supply 77

78 Axis Title inventory to almost reach parity with Children s Place but Carter s is still below industry average. Both Children s Place and Carter s are still much higher than Gap though, which is cause for concern for both firms. Due to how days supply inventory is calculated though, this is to be expected given the inventory turnover ratio for the industry discussed earlier. Days Sales Outstanding The second step in the cash to cash cycle is represented by the days sales outstanding ratio. This ratio measures the time it takes for a company to collect its account receivables after a sale has been made. The ratio is calculated by dividing the accounts receivable by your net credit sales and then multiplying by the calendar year. Firms that have a low ratio are able to collect on their accounts receivables efficiently and those with a high ratio take a longer amount of time in order to collect from their sales. By comparing ratios within the industry, we can compare how efficient a firm is from collecting on its credit sales. On the following page is a chart of the days sales outstanding ratios for Carter s and its competitors. Days Sales Outstanding Carter's Stated Disney Gap Children's Place Industry Average

79 Axis Title Carter s has the highest days sales outstanding ratio in the industry, and Children s Place has the lowest. This difference is not due to incompetence on the part of management but is due to the fact that most of Children s Place sales take place at retail locations where cash is the main form of payment. The same logic applies to Gap. Carter s on the other hand, which deals in wholesale as well as retail, takes longer to collect on their accounts receivable due to having their wholesale sales on credit. Cash to Cash Cycle The cash to cash cycle is a measurement of the amount of time it takes for a company to turn its inputs into cash. A company must first invest capital in order to acquire inventories, and once these inventories are sold, accounts receivables must be collected. We can compare the cash to cash cycle of each company within the industry in order to measure the efficiency in which a company is able to determine the rate at which they convert cash. The calculation is generated by adding the days supply inventory and the days sales outstanding in order to show the total time in which it takes for a firm to convert cash. On the following page is a calculation of Carter s and its competitors cash to cash cycle. Cash to Cash Cycle Carter's Stated Disney Gap Children's Place Industry Average

80 Overall, there is no trend up or down among firms and there is a large spread between the firms as well. The difference between Gap and Carter s is almost 50 days in the year As can be seen, Carter s is the slowest in the industry at converting cash back to cash. This shows that Carter s operations are less efficient than its industry competitors and is a cause for concern due to it meaning that they have cash tied up in inventory for a longer period of time than what is average. Conclusion When looking at operating efficiency, inventory turnover is the best indicator of a healthy firm in the baby apparel industry. This is because being a clothes manufacturer and seller requires the turnover of inventory at a very quick rate in order to generate revenues. In an industry such as baby apparel, days sales outstanding and accounts receivables turnover are not as important because a large portion of goods are sold at the retail level. As the graphs have shown, Gap has the most efficient operations in the industry with the exception of Disney. Since Disney is such a large outlier on all of the ratios it is hard to compare them to the other firms. This large difference is due to their diversity of business operations. Because of this, Disney should not be included in the ultimate analysis of operating efficiency. Carter s is either average to below average in most of the operating efficiency ratios and this is a cause for concern as there should not be such a large difference between them and their competitors. Profitability Ratios Profitability ratios measure a company s ability to generate earnings relative to their sales, equity, and assets, and show the effectiveness at which a company is being managed (ready ratios). All firms are concerned with how profitable they are, therefore companies use profitability ratios in order to analyze their bottom line and the return they are able to give to their investors (biz finance). By using profitability ratios in order to measure a company s performance and efficiency, we can compare various firms in 80

81 Axis Title the industry in order to determine whether the company is more financially sound than its competitors. Gross Profit Margin The gross profit is used to look at a company's cost of goods sold as a percentage of sales, by taking total revenue minus cost of goods sold, and dividing it by sales. By analyzing the ratio, we can see the percentage of revenues remaining after deducting the cost of good sold. Companies desire high gross profit margins as it allows them to spread their capital over more expenses such as operating costs. Below is a graph and chart of the industry s gross profit margins. Gross Profit 50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Carter's Stated 36.40% 32.70% 39.40% 41.50% 40.90% 41.70% Disney 17.67% 19.03% 20.96% 20.98% 45.88% 45.94% Gap 40.20% 36.20% 39.40% 39% 38.30% 36.20% Children's Place 39.61% 38.69% 38.21% 37.12% 35.33% 36.22% Industry Average 32.49% 31.31% 32.86% 32.37% 39.84% 39.45% Again, with the exception of Disney, all the firms in the industry are closely related and there is no overall trend either up or down. This indicates that the firms in the industry are very stable and the industry is very well established. Also, with the exception of Disney once again, Carter s has the highest gross profit margin in the industry. The restatement of Carter s financials once again does not change the gross profit margin. 81

82 Axis Title Operating Profit Margin Operating profit margin measures the amount of revenue a company has left over after it covers its operating expenses, and just like the previous ratio, gross profit margin, the higher the ratio, the more profitable that a company is. We can calculate this ratio by subtracting selling and administrative expenses from a company s gross profit and then dividing by the company s total sales. Companies must have a positive operating profit margin in order to cover the expenses of their operations. On the next page is a chart and graph of the industry s operating profit margins. Operating Profit Margin 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Carter's Stated 9.60% 8.90% 11.00% 10.00% 11.50% 13.00% Carter's Restated 8.10% 7.10% 9.40% 8.60% 10.30% 12.70% Disney 16.96% 18.89% 20.73% 20.51% 23.35% 25.21% Gap 13.40% 9.90% 12.40% 13.30% 12.70% 9.60% Children's Place 8.14% 6.41% 4.96% 4.32% 4.54% 5.22% Industry Average 12.83% 11.73% 12.70% 12.71% 13.53% 13.34% There is a large variance in the operating profit margins for the firms in the industry and there is no trend either up or down meaning the industry is relatively stable. Children s Place has the lowest margin and Disney has the highest. Carter s having a high operating profit margin, second only to Disney, shows that they are doing a good job of keeping their operating expenses down. Carter s restated financials cause the firm s operating profit to be slightly lower. The reason behind this is restating the financials caused goodwill to become an operating expense, which resulted in an increase in Carter s operating expenses. This was slightly offset though by the decrease in rent expense. Because of this, the restatements do not have a large effect on operating profit margin. 82

83 Axis Title Net Profit Margin By dividing a company s net profit, by its revenue, we can calculate the net profit margin. This is a very critical ratio for a company as it is a measure of how much of each dollar that is collected by the company results in actual profit. In order to continue to add growth to a company and maintain financial security, it is imperative that a company generates a positive net profit margin. By comparing the net profit margin of various firms in the industry, we can analyze which firms are able to generate profitable returns off of their sales and operations. On the next page is a chart and graph of the industry s net profit margins % 16.00% 14.00% 12.00% Net Profit Margin 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Carter's Stated 8.40% 5.40% 6.80% 6.10% 6.70% 7.90% Carter's Restated 6.90% 3.60% 5.20% 4.70% 5.50% 7.40% Disney 10.41% 11.76% 13.44% 13.62% 15.37% 15.98% Gap 8.21% 5.73% 7.25% 7.93% 7.68% 5.82% Children's Place 4.97% 4.50% 3.50% 3% 3.23% 3.35% Industry Average 7.86% 7.33% 8.06% 8.18% 8.76% 8.38% There is a very large spread among the firms in the industry and the values differ from year to year as well. In 2015, Carter s net profit margin is almost double that of Children s Place. This large spread is especially true for 2011 when high commodity prices had a negative effect on the industry due to increased costs of production and 83

84 transportation. At the beginning of the years being analyzed, Carter s was towards the bottom of the industry in regards to net profit margin but in 2015 Carter s is second only to Disney. This is a good sign for Carter s and shows that they are getting better at keeping expenses such as interest expense down. Carter s restated financials caused the net profit margin to fall slightly because of the the increase in operating expenses caused by Carter s goodwill Return on Assets The return on assets ratio is calculated by dividing net income by total assets. The ratio is used in order to determine how well a company utilizes its assets in order to generate a net profit. This ratio can be of particular importance when comparing industry averages with a company, as different industries must acquire different assets in order to produce and sell their products (finance formulas). Therefore, by comparing the return on assets ratio among various companies in a single industry, we can see which companies are properly utilizing their assets and generating sufficient returns. On the next page is a graph and chart of the industry s return on assets. 84

85 Axis Title Return on Assets 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Carter's Stated 12.20% 9.00% 11.50% 9.90% 10.80% 12.60% Carter's Restated 8.20% 4.90% 7.10% 6.10% 6.90% 9.20% Disney 5.99% 6.80% 7.73% 7.86% 9.07% 9.73% Gap 16% 11.50% 15.24% 16.71% 16.24% 12.13% Children's Place 9.73% 9.06% 7.13% 5.54% 5.84% 6.24% Industry Average 10.57% 9.12% 10.03% 10.04% 10.38% 9.37% Similar to net profit margin above, the year 2011 saw a sharp drop in return on assets. Taking out this one year though, the industry is on a slight uptrend with the exception of Gap. There is also a large spread among the firms with Carter s having a return on assets that is significantly higher than Children s Place, which continues to be towards the bottom of all profitability ratios. Restating Carter s financials though does lower their return on assets. The reason behind this is because the leases that were once categorized as operating leases became capital leases. This caused the assets to increase (the denominator), resulting in a smaller ratio. Like stated earlier in regards to restatements on a firm s assets, this is not much cause for concern because both Gap and Children s Place would see the same results if their financials were restated. This is significant because looking at their 85

86 Axis Title financial statements shows that their financials would need to be restated based on the operating lease stipulation that caused Carter s financials to be changed. Return on Equity In order to calculate a firm s return on equity, the company s net income is divided by the prior year s total equity. The ratio is used to determine the returns that a company is generating from the money that capital investors have put into the firm. This ratio can be very important to investors because it can show what kind of future returns they are to expect and is a measure of the amount of net income that is returned based on the equity that shareholders have invested in the firm % 45.00% 40.00% 35.00% Return on Equity 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Carter's Stated 26.40% 16.60% 20.00% 16.40% 27.80% 30.20% Carter's Restated 21.60% 10.20% 14.00% 22.20% 25.80% 32.40% Disney 11.12% 12.84% 14.73% 14.41% 16.60% 18.73% Gap 26.84% 24.37% 40.18% 42.98% 41.75% 33.29% Children's Place 13.89% 12.69% 10.28% 8.57% 9.44% 10.37% Industry Average 17.28% 16.63% 21.73% 21.99% 22.60% 20.80% The return on equity for the industry slightly decreased in 2011 and had an increasing trend the following 4 years. Carter s return on equity hovered in the middle of the pack behind Gap until 2015 where they decreased their separation and had a return on 86

87 equity just under Gap. Carter s restated return on equity trended above its previously stated return on equity because the restated financials caused liabilities to be larger. Since equity is represented as assets less liabilities, a rise in liabilities causes equity to shrink. Since return on equity is net income over the previous years equity this decrease in equity causes return on equity to be higher. Asset Turnover Ratio The asset turnover ratio is a lag ratio that is found by dividing net sales by the previous year s assets. The ratio shows how effectively a firm is generating sales from their assets. Companies with high ratios within the industry are utilizing their assets in order to generate sales. The ratio depicts the percentage of sales that are acquired for every dollar the company has invested into its assets. Companies who have low asset turnover ratios are not generating substantial profits relative to the money that they have invested in their assets. On the following page is a comparison of Carter s and its competitor s asset turnover ratios. 87

88 Axis Title Asset Turnover Carter's Stated Carter's Restated Disney Gap Children's Place Industry Average There is a large spread among firms in the industry and Gap is performing the best. In addition, the industry is very stable and the ratios do not change much from year to year. Carter s is towards to the bottom and is worse than the industry average indicating that they are not efficiently turning their assets into revenue. Restating Carter s financials causes this ratio to drop even lower. This is once again due to the increase in assets from restating operating leases as capital leases and once again, this is not cause for concern because the other firms in the industry would see the same results if their financials were restated. Internal Growth Rate The internal growth rate of a firm measures the amount that a firm is able to grow based upon the amount of capital that the firm is able to produce. The internal growth rate does not take into account any outside capital that the firm is able to produce 88

89 Axis Title through financing activities. I order to calculate the internal growth rate, you multiply the firm s return on assets by its dividend policy, which is found by dividing the company s dividends paid by the company s net income. By analyzing the ratio, one can see the rate at which the firm grows based on its operating activities and its dividend policy without taking on any liabilities from outside creditors. IGR 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Carter's Stated 11.70% 8.10% 9.90% 7.40% 8.20% 9.60% Carter's Restated 7.80% 4.40% 6.10% 4.30% 4.80% 6.80% Disney 5.24% 5.85% 6.39% 6.42% 7.38% 6.32% Gap 11.92% 8.45% 12.06% 12.84% 11.20% 7.06% Children's Place 9.72% 9.02% 7.40% 5.74% 4.64% 4.80% Industry Average 8.96% 7.77% 8.62% 8.33% 7.74% 6.06% The results above show the internal growth rate for Carter s as well as its competitors. After examining the results, Carter s as stated internal growth rate is just below Gap every year until the last year where they jump ahead with the restated internal growth rate slightly below the as stated. The restated internal growth rate is less than the as stated internal growth rate due to the increase in assets on the restated balance sheet. With this increase in assets it causes the return on assets to decrease which is a variable in determining the internal growth rate. Carter s restated internal growth rate appearing at the top of the industry shows that Carter s may be show creating more value through its internal utilization of assets compared to its competitors. This shows that Carter s runs a more efficient business in regards to operating policies and dividend policies. 89

90 Axis Title Sustainable Growth Rate The sustainable growth rate of a company combines a company s IGR with the firm s capital structure, or financing activities in order to determine the company s total potential growth rate. The ratio is calculated by multiplying the firm s internal growth rate, which measures the company s dividend and operating policy, by the company s total liabilities of last year, divided by the company s book value of equity from last year. The company s total liabilities of last year divided by its book value of equity from last year is a measure of the company s financing operations. By combining this with IGR, you are able to analyze the sustainable growth rate of the firm and compare it to its industry competitors. SGR 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Carter's Stated 25.43% 14.89% 17.17% 12.23% 21.19% 22.98% Carter's Restated 20.57% 8.26% 14.24% 9.86% 19.57% 27.04% Disney 9.81% 10.80% 12.32% 12.10% 13.19% 11.83% Gap 19.46% 14.63% 32.49% 33.14% 28.71% 18.20% Children's Place 14.09% 12.68% 10.33% 8.53% 7.46% 7.81% Industry Average 14.46% 12.70% 18.38% 17.93% 16.45% 12.61% The results above show the sustainable growth rate for Carter s and its competitors. While examining the results it is apparent that Carter s substantial growth is similar to their competitors until the final year when they jumped ahead. The internal growth rate and sustainable growth rate graphs are very similar in results. This is because one variable for the sustainable growth rate is the internal growth rate. As stated above the reason for the difference in as stated and restated is caused from the return on assets. The other variable for in the sustainable growth rate formula is lagged liabilities divided 90

91 by lagged equity. When restating the balance sheet, the total liabilities increases. This increase in total liabilities is the factor that causes the restated sustainable growth rate to surpass the as stated growth rate. Carter s sustainable growth rate being above its competitors shows that they run a more efficient business in regards to operating, dividend, and financing policies. Conclusion Overall, in the baby apparel industry, the most important profitability margin is the net profit margin. This is because it takes into account all revenues and all expenses for a firm. Based on that, Carter s is second in the industry only to Disney and is also trending up over the last two years. Disney is once again such a large outlier in all the ratios in this section that it is hard to draw comparisons between them and the other firms that produce baby apparel. Capital Structure Ratios Capital structure refers to the way a company finances its operations through debt and equity. When a company finances their operations through debt they are either issuing bonds or getting loans. When a company is using equity to finance their operations it comes in the form of common stock, preferred stock or retained earnings. Debt to Equity The debt to equity ratio will show a company how they are financing their operations. Taking the total liabilities and dividing that by the total equity measure the debt to equity ratio. Through this ratio we can breakdown the financing activities of a company. A high debt to equity ratio will reveal that the company is financing most of their activities with debt coming from loans and bonds. A low debt to equity ratio will reveal that the company is financing much of their activities through their shareholders in the form of issuing stock. A lower debt to equity ratio will usually result in a more stable company. 91

92 Axis Title Debt to equity Carter's Stated Carter's Restated Disney Gap Children's Place Industry Average As the chart above shows, debt to equity varies a lot from firm to firm and does not follow a trend either up or down. Carter s ratio is much higher than the industry average and shows that the firm is highly leveraged. While this is not a cause for immediate concern, it is something that a potential investor must take into account due to the high risk being leveraged brings with it. On the other hand, the higher ratio means that Carter s sees a higher return on equity. Carter s restated financials caused the debt to equity ratio to rise above the industry average. The reason behind this is the restatement of operating leases to capital leases caused an increase in Carter s non-current liabilities. This is not cause for much concern though because the leases were still under company control before the restatements and they were still a liability even though they were treated as an expense. 92

93 Altman s Z-Score Altman s Z-Score is calculated by taking 5 different ratios to determine how likely a firm is to going bankrupt. The formula for this is 1.2(Net Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) + 3.3(EBIT/Total Assets) + 0.6(Market Value of Equity/Book Value of Total Liabilities) + 1.0(Sales/Total Assets). The greater the score the less likely the firm is going to go bankrupt. A distressed company will have a greater problem with debt because the rates will be steeper for them Altman Z-Score Carter's Stated Carter's Restated Disney Gap Children's Place Industry Average The chart above indicates that as time has passed all firms in the industry have consolidated to around a level of 5. A Z-Score above 3 indicates that a firm is in good financial health and is not at risk of bankruptcy. One reasoning behind the industry previously having a large spread is the financial crisis of All firms were affected differently, based on various things, but as time has passed their Z-Scores have returned closer to what would be considered normal. Carter s has been and still is in good financial health for the time period that is being analyzed. The restatements cause a decrease in their Z-Score because of the reasons stated earlier regarding an increase in assets in some cases and an increase in non-current liabilities as well. 93

94 Axis Title Times Interest Earned Times interest earned is calculated by dividing a firm s income before interest and taxes by interest that is payable on bonds and other long-term debt. The ratio shows a firm s ability to pay its debt obligations based on its ability to sustain earnings. The ratio measures the amount of times that a company is able to pay its interest on pre-taxed debt in order to meet the obligations of its creditors. Companies with a high times interest earned ratio are those that carry little debt or are using excessive amounts of earnings to pay off their debts. TImes Interest Earned Carter's Stated Carter's Restated Disney Gap Children's Place Industry Average There is a large variation between firms in the industry ranging from 12 to over 53. Children s Place high ratio in this case shows they can pay their debt obligations many times over. The hole in the chart from 2012 from 2014 for Children s Place is because there is no interest expense in those years. Carter s stated and restated ratios are towards the bottom of the industry. This is not much cause for concern though because based on the other ratios above, it is apparent that Carter s is in a position to pay back its debts as indicated by ratios such as Altman s Z-Score and other liquidity ratios. 94

95 Conclusion Overall, the capital structures of the firms in the industry vary wildly from firm to firm with the exception of Altman s Z-Score. The reason behind this is that there is no particular way to structure a firm. For example, the debt to equity ratio shows that Carter s is willing to leverage themselves more than some firms and the times interest earned ratio shows the same. Disney on the other hand prefers to finance their activities via equity which is why they have a higher times interest earned ratio. Restating Carter s financials does not do much to change this picture. Forecasted Financial Statements When forecasting a company s financial statements it is important to analyze all aspects and changes in previous years in order to make a reasonable assumption about how the company will expect to perform in the future. The many different factors to consider when preparing to forecast financials not only include the company's previous financial statements but also the competitors in the industries financials and trends. There is no way to correctly forecast the future with the many uncertainties to consider, but using the information and data collected we can make an educated assumption on where the firm's future economic conditions and value drivers will fall. The data and information analyzed includes but is not limited to any trends of the industry, financial ratios of both Carter s and their competitors, and the growth rates of both Carter s and their competitors. In the following sections we will forecast Carter s income statement, restated income statement, balance sheet, the restated balance sheet and the statement of cash flows. Income Statement The first step is forecasting the income statement. The income statement is the building blocks for the remaining financial statements so it is important that it is correct. With careful analyzing of the previous trends and ratios will help us create an accurate 95

96 forecasted income statement. For Carter s we will forecast the income statement, restated income statement, balance sheet, the restated balance sheet and the statement of cash flows. The first step in forecasting the income statement is to forecast Carter s future sales. This is the foundation of all the forecasting because once the sales are forecasted the following values will correlate with the sales. We found that from 2012 to 2015 the average growth rate in sales is 8.5% but with a decreasing trend. We excluded 2011 and back because the acquisition of Bonnie Togs in 2011 will negatively reflect the present growth rate of Carter s and the clothing industry as a whole was affected by rise in the price of commodities making the ratios much different in this year. The sales growth of Children s Place and Gap had more weight than Disney s sales growth because they are more comparable to Carter s. Gap and Children s Place sales growth rate average is 2.43% therefore we concluded that the forecasted sales for Carter s will have a consistent decrease the next 3 years and leveling out at 5.5%. The as stated income statement and restated income statements sales was not changed so we will use the same ratio for both forecasted values. We found the sales for 2015 and multiplied it by the reasonable growth rate appropriate for the forecasting for the sales of We continued this process until Once the sales are forecasted we then began to forecast the gross profit. The main ratio we analyzed for this is the gross profit margin. As mentioned in our ratio analysis the gross profit margin is what percent of sales is gross profit. Carter s gross profit margin is consistently higher than the industry average the previous 5 years. We determined that a reasonable forecasted gross profit margin would be 40% which is slightly below Carter s gross profit margin of 41.7% and slightly above the industry average of 39.45%. Once we have a gross profit margin to go by we can multiply the sales by the gross profit margin through the forecasted years. This calculation was used for both the as stated and restated gross profit. 96

97 Next we forecasted Carter s operating profit. We did this by finding the percentage of operating profit to sales. The values of operating profit forecasted will be the first difference in the as stated and restated income statement due to the recognition of impairment on goodwill. On the as stated income statement the average percentage of operating profit to sales the previous 6 years is 10.7%. Again after analyzing the ratios we concluded that it would be more appropriate to use the previous 4 years average which is 11.4%. Although this is a minor difference we believe that it will better represent the future using the previous 4 years ratios. The average from the last four years is 10.3%. We used this average to calculate the restated forecasted operating profit for Carter s. The next account we forecasted is the income before taxes as a percentage of sales. The previous 4 years ratio of 10.3% better represent the future values of income before taxes due to the acquisition of Bonnie Togs in Once the income before taxes is forecasted for the next 20 years we will move on to the restated income forecasting. Again this calculation will differ from the as stated income statement due to the increase of operating expenses. The average the past four years is 10.2%. We used this average to calculate the forecasted income before taxes for Carter s. With the sales forecasted we are now able to complete the forecasted income statement with net income. To forecast the net income we used the percentage of sales as before. When comparing our ratios to our competitors it is a continuous trend that Carter s has had a higher gross profit margin than our competitors excluding Disney because they have had a continuous trend of having significantly different ratios due to their different operations. For this reason, we will use Carter s ratios. The as stated income statement percentage of net income to sales the previous four years is 6.9%. We used this percentage to forecast the next 10 years of Carter s net income. The restated income statements net income differs from the as stated one so we will have 97

98 to use the restated previous 4 years average to calculate the new average of net income to sales. We calculated the previous 4 years average of net income to sales to be 5.7%. Once we forecasted the following 10 years of Carter s restated net income we are finished with the income statement. 98

99 As Stated Income Statement 99

100 Restated Income Statement 100

101 Balance Sheet While the income statement had many values similar to the restated income statement, the balance sheet and restated balance sheets values will all be different. Since we have already forecasted the income statement we need a way to link the income statement to the balance sheet. The method used to link these financial statements are through the asset turnover ratio. This ratio compares the total assets of the previous year to the current year sales. The average asset turnover ratio for the as stated financial statements is 1.63 for the last 4 years. After analyzing the trend of Carter s, they have a constant decrease in this ratio the past four years. After analyzing Carter s trend we then compared their asset turnover ratio to the industry. Carter s continuously has a slightly higher asset turnover than the industry. Taking this into consideration we used decreased the asset turnover ratio the first 3 forecasted years leveling out at 1.55 which is slightly above the industry average. We continued this steady trend throughout our forecasting. Once we forecast this for the next 10 years we will move on to the restated balance sheet. The restated asset turnover ratio is consistently lower than the industry average due to the recognition of goodwill and operating leases. An appropriate ratio for the restated asset turnover is 1.2 due to the decreasing trend of Carter s asset turnover ratio. After linking the income statement to the balance sheet we can forecast the remaining accounts on the balance sheet. Once we have forecasted the total assets we will move on to the net receivables and inventory. To find these ratios out we will look at our ratios. The accounts receivable turnover and inventory turnover will link the accounts receivable and inventory accounts to sales and cost of goods sold. These ratios will be similar for the as stated and restated balance sheet. The average inventory turnover ratio the previous four years is To find the total forecasted inventory we will have to divide the forecasted cost of goods sold for 2016 by this ratio for both the as stated financial statements and the restated financial statements. For the accounts receivables forecasted balance we will need do the same thing as inventory but use the accounts receivable turnover ratio 101

102 instead. Again this will be the same for both the as stated financial statements and the forecasted financial statements. The previous four year average is so we will just divide this by the forecasted sales to get the accounts receivable. After we have found the total forecasted assets, inventory, and accounts receivable we then forecasted the total current assets. We found that on average Carter s total as stated current assets has been around 56% of the total assets. To forecast the total current asset we multiplied the forecasted total assets by 56%. We used the same process to value the total restated current assets. On average the total restated current assets have been 45% of the total restated assets. Next we will calculate the total forecasted non-current assets. The formula for total assets is current assets plus non-current assets. Since we have already forecasted out the total assets and the current assets we will use this formula to figure out the total non-current assets. From taking total assets minus current assets for the forecasted years we were able to calculate the total non current assets. This is used for both the as stated balance sheet and the forecasted balance sheet. With the all the forecasted assets are accounted for we began forecasting the equity. We will start with retained earnings. Retained earnings is calculated by adding net income to the previous years retained earnings and subtracting out any dividends paid that year. To get consistency throughout the financial statements, we used the forecasted net income and the forecasted dividends. Once we got retained earnings we used the same process as before for the total stockholders equity. Throughout the forecasted stockholders equity it is assumed that there is no new issuance of stock or stock repurchases. The basic concept to the balance sheet is assets equal total liabilities plus the total stockholders equity. Since we already have total assets and total owners equity we can calculate what the total liabilities is suppose to be. We went through each forecasted 102

103 year and subtracted the total stockholders equity by the total assets to get total liabilities. Once the total liabilities is forecasted we moved on to the total current liabilities. To calculate the forecasted current liabilities we used the current ratio. This ratio is current assets divided by current liabilities. Because we have current assets, we found that the previous four years the current ratio average has been 4.01% on the as stated balance sheet. By dividing the current assets by this ratio we were able to come up with forecasted total current liabilities. The restated balance sheet and as stated balance sheet did not differ in current assets and liabilities so we used the same ratio for both. The total liabilities is made up of current liabilities and non-current liabilities. Because we already have the current liabilities we are able to just subtract them from the total liabilities to come up with the total non-current liabilities. This process was used for both as stated balance sheet and the restated balance sheet. 103

104 As Stated Balance Sheet 104

105 105

106 Restated Balance Sheet 106

107 107

108 Cash Flow Statement To forecast the cash flow statement, we stated with the total cash flow from operating activities. We analyzed various ratios such as sales/cffo, net income/cffo, and operating income/cffo. We found that the ratios were very volatile. We decided to use the operating income/cffo ratio because this showed the least amount of volatility. On average the total cash flow from operating activities was 87% of the operating income. We used this number to calculate the forecasted total cash flow from operating activities. Next forecasted the total cash flows from investing activities. Again we analyzed different ratios that showed much volatility. We decided to use the relation of operating profit to cash flows from investment activities again because it showed less volatility. On average cash flows form investing activities was -43% of operating activities. We used this number to forecast the next 10 years for total cash flows from investing activities. The last thing we forecasted on the cash flow statement is the dividends paid. Carter s had not been paying dividends until We assumed that Carter s will continue to pay dividends the next 10 years. The previous 3 years the price per share has been increasing each year. We obtained the first year quarterly dividend payout per share of 33 cents which over a year is $1.32 per share. This is a high jump which we feel that it is unsustainable. We used a stair stepping method for dividends every three years. From years 2017 through 2019 we projected an increase of 12 cents per share, with the following three years increasing 16 cents per share, and the last three years increasing by 20 cents per share. The dividends forecasted out will conclude the forecasting for the cash flow statement. 108

109 Forecasted Cash Flow Statement 109

110 110

111 Cost of Capital Estimation Cost of capital is the rate of return required to make an investment. The market determines this rate, and tells you the opportunity cost of making an investment with similar risk. In order to adequately value Carter s, we calculated a discount rate, called a weighted average cost of capital (WACC), to discount the future values of the firm to the present. Below is the formula for WACC Before Tax: WACC=[(Debt/Assets)*Rd]+[(Equity/Assets)*Re] As shown, the WACC consists of both the cost of capital for debt and the cost of capital for equity. Along with this, a discount rate that is too high will produce an undervalued firm, and a discount rate that is to low will produce an overvalued firm. In order to to find the WACC we started by calculating the cost of capital for equity, and then later calculated the cost of capital for debt. Cost of Equity In order to find the cost of equity of Carter s we used the Capital Asset Pricing Model (CAPM). Using this model required us to use the risk free rate, the beta of our firm, and the market risk premium in order to find the rate of return required by equity holders. These variables relationships are defined in the CAPM formula, Ke= Beta*(Market Return- Risk Free Rate) + Risk Free Rate+ Size Premium. The beta of a firm is a measure of how risky a firm is in relation to the market as a whole. The beta of the market is equal to one, and any firm with a higher beta is considered riskier than the market, and vice versa. The size premium is a value that indicates an excess return of that calculated in CAPM due to the size of the firm. The value we used for the size premium was gathered from the size premium table 8-5 in the Business Valuation textbook, shown below. 111

112 With a market cap of $5.3 billion Carter s is placed in the eighth decile, leading to a size premium of 1.0%. In order to find Carter s beta we collected historical data for Carter s opening and closing monthly prices over the last six years. Along with this we used the S&P 500 as a proxy for the market, and calculated their monthly return rates over the last six years. Finally, we looked up the monthly rates for twenty year treasuries to find an adequate risk free rate. After gathering all this data, we ran regressions for two, three, four, five, and six years in order to find a beta for Carter s. The results are shown on the following page. 112

113 113

114 After looking at the five regressions the beta had a range from We used the one with the highest R-squared value, which was on the five-year regression, and highlighted in yellow. A high R-squared value indicates a high explanatory power of the systematic risk associated with the firm. Systematic risk is risk that is associated with 114

115 the market as a whole and not diversifiable. Using this regression, we used a beta of 0.70 in order to estimate the cost of equity used by Carter s. The published values of beta on Yahoo and Google are 0.29 and 0.69 respectively. Our calculated beta value falls very close to Google s estimation, leading us to believe we have a reliable value. The value for the risk free rate was found to be 2.20%, we got this value online through the St. Louis Federal Reserve website by looking at the yield point on monthly twenty-year treasuries. Along with this we used a MRP value of 9.0%, this value, along with the size premium were both obtained from the Business Valuation text. Using these values, we computed a cost of equity for Carter s of 9.5%. Along with this we can conclude with a 95% certainty that Carter s cost of equity lies somewhere between 5.36%-13.64%. The calculations for these values are shown below Cost of Equity Ke= 0.7(9) = 9.5% Cost of Equity with a 95% Confidence Interval Lower Boundary: Ke=0.24(9.0) = 5.36% Upper Boundary: Ke=1.16(9.0) =13.64% The five-year regression, which had the highest value for R-squared, had an R-squared of 14%. Even though this regression has the highest explanatory power of systematic risk, it still leaves 86% of Carter s risk in non-systematic risk. Non-systematic risk is firm specific risk, meaning that it is risk only associated with that firm or industry and is diversifiable. Since this R-squared value is relatively low and leaves a large amount of Carter s returns unexplained we will use an alternative method to check our cost of equity. 115

116 Implied Cost of Equity As an alternative form of calculating the cost of equity for Carter s we used the backdoor method, otherwise known as the implied cost of equity. After calculating the cost of equity through this method we then compared it to our results from the CAPM method. The formula for the back door method is as follows: Backdoor Cost of Equity Formula (Price/Book)-1=(ROE-Ke)/(Ke-g) The main differences between the CAPM method and the implied method is that CAPM relies on historical data to determine the cost of equity, where the implied uses the price to book ratio, return on equity, and the forecasted growth rate. For the price to book ratio we used For return on equity we used our average return on equity for a value of 20.48%. For the growth rate we used to forecasted growth in book value of the firm of 5.12%. Running this formula gave us a cost of equity of 7.41%. Since the cost of equity value ran through the implied cost of equity method falls within our 95% confidence interval we feel that our cost of equity found through CAPM is a reliable and reasonable estimate to use. Cost of Debt The second component needed to calculate the weighted average cost of capital is the cost of debt. The cost of debt will be lower than the cost of equity as debt is safer in the fact that debt holders will get repaid before equity holders in the case that the firm goes bankrupt, thus leading to a lower required rate of return. In order to find the cost of debt we found a weighted average of each type of debt, and their respective interest rates. 116

117 Carter s has two different sets of liabilities, current liabilities with an interest rate of 2.17% and long term debt with an interest rate of 5.25% (Carter s K). Debts Values (In Thousands) Weight Interest Rate Weight*Rate Current Liabilities Long-Term Debt 247, % 0.48% 858, % 4.10% Total Liabilities 1,106, Sum of Weighted Average Rates 4.58% As shown above, we found Carter s weighted average cost of debt to be 4.58%. This value ws found by finding the weight of each different kind of liability on Carter s 10-K balance sheets. After the weights were found we then multiplied the weight of each type of liability by their respective interest rates. Finally, we summed up the weighted rates in order to obtain our weighted average cost of debt of 4.58%. The restatements made will influence the cost of debt, since long-term debt increased. We will use the same interest rates as the stated, but the weights will be different. Below is a table summarizing the new weights and cost of debt. 117

118 Restated Cost of Debt: Debts Values (In Thousands) Weight Interest Rate Weight*Rate Current Liabilities Long-Term Debt 247, % 0.30% 1,578, % 4.52% Total Liabilities 1,826, Sum of Weighted Average Rates 4.82% The increase in long-term debt was found from adding in our capitalized operating lease liability, which is the present value of future lease obligations. With the increase in long-term debt, the weight of the long-term interest rate increased, which increased our cost of debt to 4.82%. This increase makes sense because the interest rate for long-term debt is higher than that of short-term, and with a larger weight on it the cost of debt would have to rise. Weighted Average Cost of Capital As discussed earlier, the weighted average cost of capital (WACC) is the rate of return that an investment must make in order for the firm to make a profit. To find this rate you must find the weight of debt (Debt/Assets), and multiply that by the weighted average cost of debt, giving you the firms cost of debt. After that, you then find the weight of equity (Equity/Assets), and multiply that by the cost of equity found by using 118

119 the CAPM method. Once these two values are found they are simply added together to find the firm s before tax WACC. This process is shown by the formula below. Before Tax Weighted Average Cost of Capital WACC=[(Debt/Asset)*Rd]+[(Equity/Assets)*Re] The calculations for Carter s before tax WACC is shown below. Upper Boundary Ke WACC (As Stated) Balance Sheet Value Weight Rates Weight*Rates Accounts (In Thousands (X/Value) (As Calculated of Dollars) Above) Value of Firm 5,884,674 Market Value of Liabilities Market Value of Equity 1,106, % 0.87% 4,778, % 11.05% Total 11.92% 119

120 Upper Boundary WACC (Restated) Balance Sheet Value Weight Rates Weight*Rate Accounts (In Thousands (X/Value) (As Calculated of Dollars) Above) Value of Firm 6,604,986 Market Value of Liabilities Market Value of Equity 1,826, % 1.35% 4,778, % 9.82% Total 11.17% 120

121 Lower Boundary Ke WACC (As Stated) Balance Sheet Value Weight Rates Weight*Rate Accounts (In Thousands (X/Value) (As Calculated of Dollars) Above) Total Assets 5,884,674 Market Value of Liabilities Market Value of Equity 1,106, % 0.87% 4,778, % 4.34% Total 5.21% 121

122 Lower Boundary Ke WACC (Restated) Balance Sheet Value Weight Rates Weight*Rate Accounts (In Thousands (X/Value) (As Calculated of Dollars) Above) Value of Firm 6,604,986 Market Value of Liabilities Market Value of Equity 1,826, % 1.35% 4,778, % 3.86% Total 5.21% When finding the WACC for Carter s we used the market price at the release of the 10-K of $92.89 multiplied by the number of outstanding shares in the market at that time of million shares. Along with this we gathered the market value of liabilities from the Carter s 10-K, and for the restated just added in our values for capital/operating leases. The weights for liabilities and equity on an as stated and restated basis are 19%/81% and 28%/72%, respectively. The varying rates for equity were gathered from our 95% confidence interval of upper and lower boundary betas. The varying rates for debt were gathered from the differences between our as stated and restated liabilities due to the capital/operating leases. With all of these values we can say with certainty that Carter s before tax weighted average cost of capital lies between 5.21%-11.92%. 122

123 The WACC we calculated does not accurately account for what Carter s requires on investments due to its lack of accounting for various tax rates imposed on the firm. Thus, we then computed the after tax WACC. The after tax WACC is just simply the before tax WACC multiplied by one minus the tax rate, and shown below with our calculations: After Tax Weighted Average Cost of Capital WACC=[(Debt/Assets)*Rd]+[(Equity/Assets)*Re] *(1-Tax Rate) Lower Boundary After Tax Weighted Average Cost of Capital WACC=0.0521( )= 3.26% Upper Boundary After Tax Weighted Average Cost of Capital WACC= ( )=7.45% Based on these results we can conclude that the cost of capital implemented by Carter s is in a range of 3.26%-7.45%. Method of Comparables Method of comparables is another method useful to determine the value of a firm. Due to the availability of inputs being accessible on numerous websites, this method is simple and quick to determine value. This method compares different ratios in the industry to determine if a company is undervalued, overvalued, or fairly valued. The main flaw in this method is that the information used is just over one year which could result in an inaccurate pricing. We did not use Carter s stated or restated ratios for the industry average on any of the models. Since each model only considers one or two variables in calculating each ratio, none of the models presented can stand by themselves in giving you an actual share price. But, running all the comparables can give the investor a good idea of what range the share price should be, or at least an opinion of the current share price being valued correctly. 123

124 P/E Trailing The trailing price to earnings ratio shows how much an investor is willing to pay for a dollar of earnings based on the past 12 months of earnings per share. The advantage to using trailing price to earnings is that it uses historical earnings instead of forecasted which has room for errors. We divided the price per share by the earnings for the previous 12 months for Carter s on an as stated basis and restated basis and their competitors which we found on Yahoo Finance. Once we have all the price to earnings calculated we took the industry average and multiplied it by Carter s trailing earning per share to give us an adjusted price. Carter s price per share and trailing earnings per share is relatively high compared to the competitors. The Carter s restated trailing earnings per share is lower than the as stated due to the restated income being lower. Through the calculations of both Carter s and their competitors price to earnings, Carter s is above the industry on as stated and restated basis. With the price to earnings being higher than the industry average, the adjusted price per share calculated to be lower than the current price per share making this model showing Carter s overpriced. The resulting price based on this model was $79.42, representing an overvalued current stock price. P/E Forward The forward price to earnings ratio is calculated the same way as the trailing price to earnings except the earnings per share are used from forecasted earnings per share. 124

125 When comparing trailing to forward, the trailing price to earnings can be assumed to have less errors due to using historical earnings. Forward price to earnings relying on the accuracy of forecasted earnings per share is something to take into consideration because there is no way to predict the future correctly. We used forecasted earnings from our forecasted values for Carter s and found the forecasted earnings per share for the competitors on Yahoo Finance under the Analyst Estimate section. The forecasted price to earnings for Carter s is much higher than their competitors on both as stated and restated basis. The restated earnings per share was lower than the as stated again due to net income. Carter s forward price to earnings being even higher than the industry average on price to earnings in comparison to the trailing earnings per share shows Carter s being more overpriced than before. This shows consistency throughout both models though that further assures us that they are overpriced. Price to Book The price to book ratio shows the relationship between the price per share of the company and its book value on a per share basis. This is calculated by dividing the price per share by the book value per share resulting in the price to book ratio. With a low price to book ratio compared to the industry average will conclude an undervalued firm and vice versa. The variables were obtained from Yahoo Finance for the competitors price per share, book value per share, and Carter s price per share. We used Carter s financial statements to calculate their book value per share. 125

126 Throughout our calculations, Carter s price to book ratio is much higher than the industry average on both an as stated basis and restated basis. The restated price to book ratio is less than the as stated resulting in a lower price to book ratio but still much higher than the industry average. A higher book to value ratio than the industry average results in a lower adjusted price per share. This model again shows Carter s being overvalued which is consistent with the forward and trailing price to earning models. Dividend to Price The dividend to price model is another model that compares dividends per share by the price per share. To calculate the dividend to price ratio we divided per share by the observed share price on April 1, We used Yahoo Finance to find Carter s observed share price, the competitor's observed share price, the competitor s dividends per share, and Carter s dividends per share. Throughout our model, Carter s dividend per share is close to the industry average. With Carter s observed share price being above the industry average it made our 126

127 dividend to price ratio lower than the industry average. The adjusted price per share resulted to be much lower than Carter s actual price per share. There is no restated dividend to price ratio because dividends do not change when restated the financials. A lower adjusted price per share in the dividend to price model shows Carter s being overvalued. This model does not have much weight when analyzing if they are actually overpriced because they are relatively new in paying dividends. Even though we do not think this model will accurately represent Carter s, it is consistent with the previous models being overpriced. Price Earnings Growth The price earnings growth ratio reflects a company s price to earnings ratio divided by the average forecasted earnings growth rate for five years. In the trailing price to earnings model, we calculated the price to earnings ratio. The growth rate of earnings is the growth rate used in this model. The values used in this model were found by dividing the price to earnings ratio by the next year annualized growth rate of earnings. The forecasted income statement was used in order to find these values. Running this model gave us an industry average of Carter s price earnings growth 4.49 which is much higher than the industry average. A much higher price to earnings than the industry will result in a sharp decline from the observed share price and the adjusted price per share. Carter s adjusted price per share came out to $9.08 which is well below the 10% range of fair values leading to an overvalued result that is consistent with the previous models. 127

128 Price to EBITDA The price to EBITDA ratio is calculated by dividing the company s market capitalization found on Yahoo Finance by its earnings before interest, taxes, depreciation, and amortization. The market capitalization is found by multiplying the number of outstanding shares by the observed share price. This ratio is valuable when determining the value of a company but it does not include interest, taxes, depreciation, and amortization which can amount to a large amount of money. The price to EBITDA industry average of 7.98 calculates to be much lower than Carter s price to EBITDA of Carter s share price is high compared to the industry average making both the market cap and price to EBITDA high. The adjusted price per share resulted to be much lower than the current price per share making this model's conclusion being overpriced. Price to Free Cash Flows The price to free cash flows model is based on a firm s market capitalization and its relationship to its free cash flows. Market capitalization is found by multiplying the number of shares outstanding to its current stock price. Free cash flows are found by taking the cash flows from operations plus or minus cash flows from investing. Cash flows are generally very volatile and hard to predict with accuracy. Due to this, this model is not as reliable as other models implemented. 128

129 When running this model Disney was excluded from the industry average due to their free cash flows significantly skewing the results. With this given assumption, the price to free cash flows industry average is is lower than Carter s ratio of This model also gave Carter s an adjusted price per share of $54.84, which falls below the 10% range, resulting in an overvalued firm. Enterprise Value to EBITDA The Enterprise Value of a firm is calculated by adding the market value of equity to the book value liabilities, then subtracting the firm s cash and financial investments. To calculate the ratio of EV/EBITDA, we used the enterprise value of each firm, divided by the EBITDA. We calculated Carter s enterprise value for both stated and restated, and used Yahoo Finance for its competitors. When calculating the Market Cap divided by each firm s EBITDA, we came to an industry average of Both Carter s stated and restated had a ratio significantly higher than the industry average, which caused another overvalue adjusted price per share. This provided an estimated share price of $53.40 for Carter s stated and $

130 for Carter s restated. These numbers represent an overvalued current share price, but this is only one model so it cannot fully support the new calculated share price. Intrinsic Valuation Models Another method to value a firm is to use intrinsic valuation models. Intrinsic valuation models are more reliable than the methods of comparables due to the fact that they incorporate firm specific values, and that they use ten years of forecasted values in order to evaluate a firm. Along with this, they also utilize present value formulas in order to bring future benefits back to the present time. The intrinsic valuation models we will use are the discounted dividends, free cash flows, residual income, and long term residual income. We will run these models for the as stated financials as well as the restated financials where appropriate. We will be using a 10% confidence interval for an acceptable stock price range for Carter s. This will be based upon Carter s March 31st closing price of $105.38, giving us a range of $94.84-$ for a fairly valued share price. Anything below will result in an overvalued price, and anything above undervalued. Discounted Dividends Model Discounted dividend model values a stock using the present value of all future dividends. It is assumed that there is no issuance or repurchases of stocks throughout the forecasted dividends. A discounted dividend model is most appropriate in firms that focus heavily on dividends. This model is a relatively simple model but is the most inconclusive. The results of this model will show if a firm is fairly priced, overvalued, or undervalued. When valuing Carter s, the discounted dividends model is not the best representation of the stock price. Carter s did not pay dividends until 2013 with the previous three years 130

131 dividends paid growing at a fairly constant rate. We used this to stair step forecast Carter s future dividends. After forecasting all ten years of dividends, we then calculated a perpetuity for the present value of Carter s dividends in After this, we brought all forecasted amounts back into 2015 values through the present value formula by our estimated cost of equity. Finally, we forecasted this amount to March 31st, 2015 to get a time consistent value.the results are listed below. Carter s observed price on April 1, 2016 is $ We used a 10% analyst approach on our model giving us a small range for fairly valued stock prices. The result are consistently red, meaning overvalued. The only exception is with a 5.12% growth rate and a 5.36%. Due to these rates being just slightly off, it results in skewed prices. Based on this, Carter s dividends account for around 25% of their stock price, resulting in a model that is not very reliable. Discounted Free Cash Flows Model The next intrinsic model used was the discounted free cash flows model. This model assumes that the market value of equity can be found from subtracting the market value of liabilities from the market value of assets. The market value of assets is equal to the present value of all future free cash flows. Free cash flows are those that are 131

132 available to enhance shareholder value. Furthermore, we assume the market value of liabilities is equal to the book value of liabilities. In order to find the forecasted free cash flows, we subtracted our cash flows from investing from our cash flows from operations from our forecasted statement of cash flows. After we did this for the next ten years, we then found the terminal perpetuity value for year We then brought all of these values back to present values by a before tax weighted average cost of capital in order to get our market value of assets. We used the before tax WACC to avoid accounting for taxes more than once, as cash flows are stated on an after tax basis. Once we found our market value of assets, we then subtracted our market value of liabilities in order to get the market value of equity. Finally, we divided this amount by the number of shares outstanding to get our estimated share price of Carter s. As our results below show, we used the same 10% confidence interval that was used in the discounted dividends model. Along with this, we also used our estimated before tax WACC calculated in the cost of capital estimation section, as well as the upper and lower boundaries to discount back the free cash flows. This model also resulted in Carter s generally being overvalued. However, due to the volatility of the free cash flows in this model it does not have a very high explanatory power of the stock price. This model produced slightly more accurate results for Carter s share price, but still represented an overvalued price. 132

133 Residual Income Model The next intrinsic model we ran was the residual income model. This model traditionally has the highest explanatory power, as it relies on current values and short term forecasts. This is due to the fact that forecasts are less accurate the farther out in time they go. This model relies on the current value of equity, forecasted net income, and the forecasted dividends, all of which can be forecasted with more accuracy than free cash flows. This model then relates forecasted net income by a benchmark net income derived by multiplying the previous year s book value of equity by the cost of equity. The difference between the forecasted net income and the benchmark net income is the residual income. To run this model we first found the next ten years book value of equity by adding each year s forecasted net income minus that year s forecasted dividends to the previous years book value of equity. After this, we then calculated each year s benchmark net income by the process stated above. Next, we forecasted each of the next ten years residual income by finding the difference between these two amounts, and calculating the perpetuity value in Then, we brought all of these values back to their present values by discounting at the cost of equity. We then added the present values to the current book value of equity to find the current market value of equity. Finally, we divided this value by the number of shares outstanding and forecasted to get a time consistent price for this model. When running this model we used the same 10% confidence interval for a fairly priced stock. Along with this, we used our estimated cost of equity as well as the estimated upper and lower boundaries to discount back to the present. Negative growth rates were used in this model due to the growth rate being the rate at which the firm reaches equilibrium between the benchmark net income and actual net income. A growth rate with a lower value will result in approaching equilibrium at a quicker rate. This model 133

134 resulted in Carter s being dramatically overvalued at all possible costs of equity and growth rates. Residual Income Model (Restated) Due to the restatements having a material effect on net income as well as the book value of equity in our forecasts we ran the residual income model for our restated financials. The process was the same as it was with the residual income on the as stated financials. This gave us the same overall results as the as stated, but with lower results due to a lower net income. Long Term Residual Income The last intrinsic valuation model we ran was the long term residual income model. This model is similar in many aspects to the residual income model, mostly in the fact that it calculates market value of equity in order to determine share price. However, it differs in the fact that it does not require a forecast of net income, and that it incorporates return on equity as well. The formula for this model is as follows: 134

135 MVE=BVE[1+((ROE-ke)/(ke-g))] As this formula shows, there are three different variables that can be multiplied by the book value of equity; cost of equity, return on equity, and a growth rate. Due to this, we ran three sensitivity analyses, in each one holding a separate variable constant. Our return on equity was calculated by the forecasted value of net income divided by the previous years book value of equity. The cost of equity is the same that has been used in previous models and calculated in the cost of capital estimation. The growth rate is the same used in residual income. 135

136 When running this model the variable that was held constant was held at a central value; for cost of equity the value was our estimated cost of equity (9.5%), for growth it was our central growth rate (-30%), and for ROE it was our average (25.52%). We used the same 10% confidence interval as used in the previous models. This model resulted in the same evaluation as did the residual income model. However, it resulted it much lower results and an even more overvalued stock price. Long Term Residual Income (Restated) The restatements materially affected the the book value of equity and net income. The same process was used as before but the return on equity is slightly lower. This causes the restated long term residual income model values to altered slightly compared to the as stated long term residual income models. Throughout this process the conclusion that the models show Carter s being overvalued remains constant from as stated to restated. 136

137 Valuation Conclusion When evaluating Carter s Inc. we ran various valuation models that were either methods of comparables or intrinsic models. Along with this, we used a 10% range from Carter s March 31st closing to price for a fairly valued stock. Methods of comparables were models that included competitors in the industry and either past performance or short term future forecasts in order to evaluate. These models included trailing P/E ratio, forward P/E ratio, price to book ratio, dividend to price ratio, price to earnings growth ratio, price to EBITDA, price to free cash flows, and enterprise value to EBITDA. All of these models resulted in an overvalued stock price for Carter s. Intrinsic valuation models are thought to be more accurate as they use firm specific information when evaluating a firm. The intrinsic models ran were the discounted dividends model, discounted free cash flows, residual income, and long term residual income. Just like the methods of comparables these models resulted in an overvalued firm. 137

138 Appendix Goodwill Impairment Schedule Year Goodwill (Stated) Amortization Expense Ending Balance Goodwill Restated Year Beginning Balance New Impairment (27.31) (27.31) (27.31) (27.31) (27.31) 0 New Impairment** (10.42) (10.42) (10.42) (10.42) (10.42) Ending balance

139 Regressions 139

140 140

141 Amortization Schedule 141

142 142

143 143